Brokers, or Just Broken? What China’s Reforms Won’t Fix

(Bloomberg Opinion) -- Beijing is loosening the reins on its large brokerages as the financial system looks ever creakier. Previous attempts to build a Chinese version of Goldman Sachs Group Inc. haven’t had much luck. This time may be no different.

China’s capital markets are in desperate need of reform, and securities companies are key to their growth and luring in foreign investment. The China Securities Regulatory Commission revised draft regulations in recent months that rate the financial standing of brokers and focus on an increasing worry, their capital buffers. Yet the new rules will do little to force more scrutiny or to strengthen the largest brokerages, which are testing them in a pilot program. Instead, a key change in how metrics are calculated will lead to a potentially dangerous outcome: Brokers who helped drive the market off a cliff five years ago will once again be able to expand their balance-sheet leverage. 

China’s brokers aren’t in the strongest position. Much hope has been pinned on reforms for the Nasdaq-like ChiNext board, which may help increase initial public offerings, and on the over-the-counter National Equities and Exchange, a potential aid to investment banking. Various other changes over the years haven’t resulted in the desired first-class world brokerage, and neither will these if the institutions aren’t robust and sophisticated enough to operate alongside foreign peers. 

Unsurprisingly, brokerages’ latest results showed weaker profits as investment returns dropped and credit costs rose. Their underwriting business declined in May. Capital cushions are thinner. Covid-19 played a part, but there’s more. The regulator put these firms in a precarious situation last year, asking them to take over from jittery minor banks to provide financing to small and medium enterprises. As my colleague Shuli Ren and I wrote, brokers aren’t banks and don’t take deposits or create money. To ease rising pressure on buffers, the regulator last month loosened rules to allow securities companies to issue subordinated bonds more widely and raise more money. 

Another business they often rely on for profits: Proprietary trading. In a crowded market, this helps differentiate stronger from weaker firms. However, it comes with its share of credit risks. In the West, the influence of the Volcker Rule inhibits banks from aggressive investment activity using their own balance sheets. Critics believe it constrained market liquidity. In China, securities companies have been issuing piles of short-term debt to bolster this activity, along with margin lending. To be fair, leverage levels aren’t all that high at Chinese brokerages compared to their international peers. However, the ways they put their balance sheets to work are riskier and more opaque, reflected in credit costs in the first quarter. Since the end of 2019, client assets in these segments have risen by as much as 37%.

That’s a worrisome backdrop to the changes now under way. The regulator is allowing brokers to work out their ratios in a manner that encourages this leveraged activity and ratchets up risk. Instead of calculating capital adequacy ratios from the parent’s balance sheet, brokerages can now use their consolidated subsidiaries, which typically have lower leverage. Goldman Sachs estimates leverage could look as much as 25% lower for firms in the pilot program, making their capital cushions appear thicker. Changes in determining risk-weighted assets also reduce their burden.

The worst part: It’s all purely to show standing on paper. There isn’t a framework around risk management. The changes don’t spell out what is and isn’t allowed, such as restricting activities that take on excessive credit risk. That leaves plenty of room for misinterpretation and miscalculation if the program is expanded to smaller and weaker securities companies.

To be clear, leverage isn’t a bad thing. The risk lies in how and where brokers use it. These changes mean that they’ll be able to invest more with the same amount of equity. The move to allow more leverage could ultimately help China’s capital markets look and even feel more mature. Brokerages can also help support market-making, trading liquidity and credit growth. All this could be useful if these institutions can convert the extra wiggle room into higher return on assets and equity.

The question is whether they can handle such an experiment. Previous attempts to give securities companies more balance-sheet runway didn’t end well. In 2015, aggressive lending on margin and for pledged stock drove leverage growth. The market crash forced regulators to pull back. Rules around total asset to total equity ratios (leverage), capital and liquidity were introduced in 2016 to ensure these firms could manage market volatility and act more closely in line with Basel III, a guide for international banks and brokers.

Four years on, and not much has changed. Following the leverage rules, pledged lending on stock grew in 2017. Regulatory restrictions on sales by shareholders weakened the loans and opened securities companies up to losses. The following year, they faced liquidity risks as authorities cracked down on market scandals. The latest regulations won’t help tame the boom-and-bust cycle.

With the compounded effect of the trade war and Covid-19 straining the economy, China is attempting to bring in foreign institutions and money at an ever-quicker pace. The last thing this financial system needs is to further weaken institutions and let them go awry with indiscriminate lending. Experiments can have unexpected results.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

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