Risk causes and legal regulation of the financing trust

Dec 08, 2021 By Ken Becher

According to the specific transaction structure and types of financing trust, its characteristics are generally shown as follows:

First, financing trust emphasizes the debtor-creditorrelationship. The trust company initiates a trust plan to raise funds, so that the trust company can participate in the financing projects of the financing party as a creditor—thus the two form a debtor-creditor relationship.

Second, the purpose of financing trust is to enable financiers to repay capitalwithinterest and seek fixed returns.When designing trust products, the trust company and the financing party usually agree on the date of principal repayment and interest payment and the fixed financing principal and interest price.

Third, the financing trust takes the financing demand of the financing party as the starting point of driving factor and business. Financing trusts generally have clear financing parties and financing projects before the trust projects are established. That is, if there is no definite financing party and financing project but only a trust product—it does not belong to financing trust.

It is precisely because the financing trust originates from the capital needsof the financing party, the trust company is in a passive position in this kindof business. What the trust company plays in this kind of business is the function of capital channel, rather than the original business inherited from the history of trust—that is, "entrusted by others, and help others manage their finances"—which contains the gene of active management. This makes the business practice of financing trust contain multiple risks, which not only attracts the focus of financial supervision, but also brings the transformation pains that trust companies are forced to return to their original business.

The exploration inrisk causes is the premise of risk management.According to risk sources, the risks of financing trusts mainly originate from internal trust companies and external counterparties.

Internal risks of trust companies

Trust companies’ dereliction of duty and violation of regulations are one of the reasons for the outbreak of risks. At present, trust companies' cognition of their own risk control capability is too subjective—they do not pay enough attention to compliance, and there are always violations, which has also misled investors' cognition. The internal risk of trust companies runs through all links before, during and after the establishment and completion of financing trust projects.

1. Ex ante risk

Before the establishment of a trust project, the trust company needs to conduct a comprehensive due diligence on the counterparty (the financing party) and make a detailed consideration of risks. Among the risk events collected by the author, trust companies generally make the due diligence process a mere formality. For example, due diligence is conducted only through the information provided by the financing party, which result in a large difference between the due diligence results and the actual situation. Or trust companies only pay attention to the book information and past performance of the financing party in the due diligence, while ignoring the existing management level and management team, and they do not predict the long-term development of the financing party, thus risk events eventually occur.

In addition, the threshold for some companies to issue trust products is too low, especially the government credit trust. For example, when some trust companies provide financing to local governments, they will release financing funds as long as the local governments provide guarantees, instead of prudently reviewing whether the guarantees of local governments are in violation of regulations. Once the financing party is short of funds and the local finance is unwilling to repay, the trust plan will be overdue, which will lead to the failure to pay the principal and interest on time.

2. Interim risk

In the operation of trust projects, some trust companies underestimate the management and supervision on financing parties, resulting in the frequent occurrence of risk events. Among the risk events collected by the author—when the financing party has capital chain fracture or liquidity risk, while the trust company does not timely require the financing party to increase credit or take preservation measures for the financing parties’property—this will eventually lead to huge losses. If the trust company's ability to identify risks is weak, and the response to take measures is slow, it will miss risk signals in the early stage, which will spread the risk and eventually lead to cashing problems.

3.Ex post risk

When the trust project cannot be completed normally and there is cashing risk, the trust company will give priority to dealing with the collateral of the counterparty.However, the process of using the collateral of the counterparty to repay the debt is complicated and time-consuming, and the value of the collateral will also change over time. Therefore, trust companies often can not obtain the corresponding funds in a short period of time and can not return the expected income and principal to the client in time. For the sake of their own reputation, some trust companies will choose to use their own inherent funds or related parties’funds to advance, so that they can distribute the investment principal and expected income to investors, and "clear up the mess" of trust projects, that is, so-called "rigid payment".

However, the risk of "rigid payment" is that if the amount of compensation exceeds the trust company's affordability,it will lead to the actual default of the trust project, then further result in the liquidity risk of the trust company, and finally make the trust company itself face the bankruptcy crisis. At present, many regulatory policies have been issued to try to cancel the "rigid payment". They prohibit trust companies from making guarantee promises, and implement the concept of "sellers do their own duties and buyers bear their own responsibilities", which alleviates the payment pressure of trust companies to a certain extent, but also puts forward higher requirements for the control and supervision capability of trust companies. Trust companies also need to consider how to resolve risks without affecting their own reputation when there are risks in trust projects.

Credit risk of the counterparty

Risks originating from external counterparties are the main reason for the occurrence of risk events in financing trusts.Credit risk mainly refers to the risk of loss of trust property or company property caused by the counterparty's inability or unwillingness to perform the contract, including the counterparty's own credit risk and its credit risk caused by the external economic environment and policies.

1.The counterparty's own credit risk

The credit risk of the counterparty itself includes problems and difficulties in its own operation and failure to achieve the expected income level, as well as the dishonesty and malicious violation of the counterparty, which finally leads to problems in the operation of the project.

The counterparty's own operation problems includethe company’s decision-making mistakes, capital chain rupture, management changes, etc. The situation that the counterparty is dishonest, maliciously violates the law, and deliberately defrauds the trust funds for other purposes will also lead to the occurrence of the risk of the trust project.

2. Credit risk of counterparties caused by external economic environment and policies

Another reason for the credit risk of counterparties is the changes in the external economic environment and policies. This type of situation is reflected in real estate financing trusts, industrial and commercial enterprise financing trusts, and government-trust cooperative trusts.

(1) Real estate financing trust

The development of real estate financing trusts is obviously affected by policies. The reason why real estate financing trusts have experienced irrational growth with a rapid increase in projects and fast expansion of capital scale in recent years is that the cycles of real estate financing trusts are generally short-term, and the real estate industry has promoted the development of related trust projects. With the introduction of a series of regulations and policies and the implementation of intensive and strong supervision, “no speculation in housing” should be adhered to and the smooth operation of the real estate market should be ensured to be the general keynote of future supervision. However, this will also lead to an increase in real estate trust financing costs and a decline in scale.

In the long run, these policies can effectively curb blind growth, but in the short term, they will increase the possibility of default by real estate financing projects. Since the cash flow of real estate projects is greatly affected by policies, and the annual interest rate of real estate trusts is higher than that of real estate development loans, the introduction of policies may cause difficulties for real estate financiers to return sales funds, worsen cash flow, break the capital chain, and fall into financial predicament. If the financier’s credit is deteriorated due to insolvency and cannot be realized or refinanced in the market, it will generate risks.

(2) Government-trust cooperative trust

Since 2019, government-trust cooperative trust projects have been greatly affected by policies and the economic environment, and many risk incidents of government-trust projects have happened. In the past, the risk of such projects was much lower than that of other types because the local government infrastructure construction financing platform companies (hereinafter referred to as “platform companies”) in government-trust projects did not have a subjective willingness to default. Once there was a risk, the government would actively take measures to rescue. However, since the introduction of the “Asset Management Regulations” issued on April 27, 2018, rigid redemption has been broken, and “cover-ups of government” in government-trust projects are not allowed. Some risk events have arisen.

The credit risk of the platform company is the risk that the platform company cannot implement the repayment funds on time, causing the failure to repay the loan. If the guarantor cannot bear the guarantee responsibility, the trust project cannot be completed when it is due, and the interests of the trust company and investors will be damaged. Specifically, in addition to problems with their own operations, the reasons for the credit risk of platform companies are also related to the economic and financial strength as well as the financial transparency of the local government.

The completion of government-trust projects depends on the completion of infrastructure construction undertaken by the platform company. Platform companies choose to borrow high-interest debt from trust companies to complete financing needs because of the large scale of investment and low cash inflows in infrastructure construction projects. Some companies have low credit ratings and cannot obtain low-interest funds from banks. The platform company is usually a wholly state-owned company funded by the government, which maintains close contact with the government in the aspects of equity structure, personnel, business and capital. When it undertakes infrastructure construction, it will select the winning construction unit through bidding. After completion, the project will be transferred to the corresponding institution for operation. In the whole process, due to the participation of multiple parties, there will be much uncertainty, low efficiency and time-consuming problems. Besides, the infrastructure construction project may not be finished on schedule, making the trust project overdue. At the same time, since the registered capital of platform companies is mostly public facilities, which are non-operating assets, they can neither generate income nor be redeemed in a crisis.

In short, if the local government has weak economic and financial strength and low financial transparency, and there is a lack of comprehensive debt management and early warning mechanisms, the introduction of de-government credit policies will greatly increase the credit risk of platform companies. In addition, from an overall point of view, if these risks cause the default of trust products and damage the interests of investors, not only will the end of the project be brought, but also the development of financing projects in the entire region will be hindered. Once the credit of the local government is “bankrupt”, risks will be transmitted from the trust industry to the financial industry, leading to a greater crisis.

(3) Industrial and commercial enterprise trust

Industrial and commercial enterprise trusts need to judge and control the macroeconomy and the market. Macroeconomic changes will affect the operating pressure and cash flow tension of small- and medium-sized enterprises, which may cause credit risks for counterparties.

The orientation of policies is also easy to cause the overall development of some industries to get into trouble. For example, the current direction of industrial and commercial enterprises is green enterprises, and industrial and commercial enterprise trusts are also moving towards green trusts, cautiously setting up trust projects for some industrial and commercial enterprises that cause pollution.

(4) The potential expansion of credit risk: financial systemic risk

In today’s financial market, trust products closely link various financial institutions through investment. When the investee breaks out a credit risk event, it will be transmitted to the financial institution as the investment subject, affecting the stability of its operation and even inducing financial systemic risks. Since the source and investment of funds of intra-industry trusts and asset-backed securitization trusts involve multiple financial institutions, once the credit risk of the counterparty arises, it may cause financial systemic risks.

In intra-industry trusts, market risks influence more financial institutions. If the bank acts as a counterparty to the transaction, when it releases a large amount of off-balance-sheet assets, large-scale redemption problems will occur, which will not only cause losses to investors, but also affect the normal operation of the bank due to the liquidity risk, causing the bank’s own credit risk. Although the bank has a relatively low-cost fund pool, its other businesses will be affected one after another at this time, and the bank itself may also face bankruptcy. Trust companies related to banking business cannot be protected from risks because they simply serve as channels. Rather, the credit risk of the counterparty will affect the trust company and generate reputation risk and fiduciary accountability risk.

The credit risk of an asset-backed securitization trust exists on more than a specific counterparty. It exists in the initial financing party. However, due to the characteristics of asset-backed securitization, the issuer will transfer the risk to investment banks, pension funds, mutual funds and other investors after the issuance. Investment banks use various traditional or innovative methods to package and reorganize the initial securitized assets, so that the bearer of credit risk will be transferred to the next level, which means that other investors will take risks after purchase. When the government implements a monetary tightening policy, or when the market or the economy is slumping, once trust assets depreciate and credit enhancement measures are incomplete, they will directly turn to losses. In addition, as securitized products circulate in the secondary market, the policy trend of relevant financial derivatives trade and management will also generate risks. The risks of asset-backed securitization are transferred at different levels in the credit market. Therefore, once the government implements a monetary tightening policy or an economic crisis occurs, the risk will spread to the high-quality market, leading to systemic risks.

Risk prevention and legal regulation of financing trusts

It can be seen from the characteristics of financing trust risks which mostly stem from the credit risks of trust companies and counterparties that at present, trust companies lack relevant regulations when conducting trust business. When risk events occur, the solutions to handle problems are relatively messy because there are deficiencies in the internal risk management of trust companies and the relevant laws are not sound. Therefore, the prevention of financing trust risks should start from the internal risk prevention and control of trust companies and the legal regulation of the trust industry.

1. Internal risk prevention and control measures of trust companies

The optimization of the internal risk management system of trust companies is the key to the prevention of financing trust risks. According to the general business process of a trust company, risk prevention and control can be divided into three links: feedforward, concurrent, and feedback control, in order to realize the separation of decision-making and transaction, and separation of property operation and monitoring and custody to ensure that risks are controllable.

a. Feedforward stage-- due diligence and performance bond

The way for trust companies to prevent risks at the feedforward stage is to improve due diligence and arrange a performance bond mechanism. The purpose of a performance bond is to convert the collateral into working capital as soon as possible when confronted with a redemption crisis. The trust company should evaluate and account the collateral and add guarantees and compensation reserves to the collateral. When the market value of the collateral during the existence of the trust has dropped severely compared with the initial appraisal value or is even unable to cover the number of the principal creditor’s rights, the counterparty shall be required to add the collateral.

b. Concurrent stage-- monitoring risks and strengthening credit enhancement

In proceeding trust projects, the internal control system within the company should be improved, project risk management be strengthened, and the implementation of credit enhancement within transactions be ensured. In particular, it is necessary to monitor the assets during the existence of trust projects, disclose dynamic information in time, and regularly visit counterparties to understand their business conditions, so that risk signals will not be missed, and the opportunities for risk disposal will not be delayed.

c. Feedback stage-- risk compensation and attributing liability

When the trust project expires, the trust company shall have adequate guarantee measures, fully implement the responsibility for handling trust breach of contract, clarify the attribution of liability, and promptly remedy the existing risks. Specifically, it refers to establishing a self-insurance risk reserve system, and setting up a risk reserve according to the plan; directly amortizing the loss to the cost and bear the risk, and if the bad debts incurred by the trust company in the current year exceed the bad debt reserves of the last year, it shall be included in the current cost; and gradually establishing the lender of last resort system.

2. Legal regulation of the trust industry

a. Clarifying the obligations of the trustee

Trust companies should strengthen the obligation of risk warning, namely, making good estimates and control of risks before fulfilling their risk notification obligations, which also means the improvement of due diligence and the arrangement of a performance bond mechanism. Due diligence is the first step in risk prevention and control, which cannot become formalistic. A full and comprehensive analysis of the counterparty’s risk is more important. Detailed investigations should be conducted on the operating status, management status, and operating team of the counterparty, so as to avoid risks before establishing a trust plan. When performing the risk notification obligation, the trust company shall also ensure that the risk situation is discussed in detail and achieve the effect of warning, and at the same time, it shall clarify the attribution of the responsibilities of both parties.

b. Breaking “rigid payment” and implementing trust property registration

Rigid redemption has long been regarded as an “unspoken rule” in financing trust business, requiring the trust company to allocate the principal and income to investors when it is difficult to redeem the trust plan. In the early days, rigid redemption could attract investors to buy trust products, but when the trust industry develops to a certain extent, the regulatory thinking should change.

Therefore, only by stipulating the scope, form, and publicity of trust property registration, can the independence of trust property be truly guaranteed, so as to function isolation of risk, avoiding property overlap and confusion of property interests, fundamentally breaking the rigid payment, and reducing the risk of financing trusts.

c. Clarifying the trustee’s liability for compensation

At the beginning of the establishment of a trust plan by a trust company, the responsibilities of the trustor and the trustee should be clearly stipulated. Especially when trust products are at risk or in crisis, the responsibility for breach of trust should be clearly identified, and the rights and obligations of both parties should be clarified. In the course of a project, if the trust company causes losses due to its own breach of contract, negligence of duty or violation of regulations, it shall assume full responsibility without exemption, and the trustor has the right to claim for compensation from the trustee.

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