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Wednesday, April 29, 2020
Yuan You Bao Incident Exposes Risks in China's Big Banks
ANBOUND

The Covid-19 pandemic outbreak has triggered the volatility in crude oil prices, leading to the blow-up of the Yuan You Bao, or literally “crude oil treasure” futures product of the Bank of China (BOC). There has been a lot of discussion and analysis on the cause and effect of this "Yuan You Bao incident", investment loss, product design, risk of crude oil futures trading, as well as the measures taken by the BOC during the incident. The problems and lessons involved in the product itself have been relatively clear. Yet, in the view of ANBOUND, the problems of Yuan You Bao may be the tip of the iceberg. The drama that erupted at BOC is in fact rather complicated. If the risk control system in the banking sector is not trustworthy, then anything can happen to the entire banking system.

While many banking institutions in China, such as Industrial and Commercial Bank of China (ICBC)and China Merchants Bank provide similar financial derivatives trading service, the Yuan You Bao incident happened in BOC was intriguing. It exposed the defects in internal departments such as product design, promotion, trading operation, and risk control, and even many bank employees were investing in the product where there were huge losses. This also reflected various contradictions in the development of BOC. Some former BOC bankers believe that the BOC's internal front-end and back-end disjointed, especially the internal risk control system may have a major failure and defect. In particular, the BOC's mechanism has been rigid in recent years, and a large number of talents have been lost. The appointment of mediocrity and non-professionals has caused problems in the overall professional ability and risk prevention mechanism. Some BOC employees believe that in these two years, BOC is actually in a passive state of strategy. Whatever the other banks did, BOC followed suit. The direction and intention of the strategic development were not clear, and they just learned nothing from the other banks. BOC not only suffered losses on its bond investments during the 2008 financial crisis. In recent years, the BOC made the pitfalls in its bank guarantees for bond default enterprises such as the Port of Dandong, Northeast Special Steel, and Dalian Machine Tool. According to Caixin, BOC's professionalism has deteriorated significantly in recent years. Foreign exchange settlement, as the core business of BOC, its scale has been surpassed by that of ICBC in March. One can even say the BOC's performance on risk control this time reflects that the bank is somewhat unreliable.

As far as Yuan You Bao is concerned, there are multiple risks in itself. In 2013, ICBC was the first to launch a similar "paper crude oil" product. Later, China Construction Bank, Bank of Communications, and many large and medium-sized banks such as BOC and Agricultural Bank of China began to launch similar products with similar designs. But this kind of product only serves as the record of the China Banking Regulatory Commission (CSRC). Its essence is divided into two levels. On the one hand, the bank acts as a virtual exchange and a market maker, accepting investors' split trades linked to the price of crude oil futures, and earning transaction fees. From this aspect, the bank is not responsible for investors' gains and losses. On the other hand, however, it is not just a channel for trading to the outside world, but a way for investors to "narrow" their positions into one-to-one trading on overseas oil futures exchanges. In this way, the bank not only earns the difference between the two transactions, but also gets the benefits of taking up customer funds, interest, and so on. But at the same time, banks will be exposed to market risk, exchange rate risk, operational risk, and the credit risk of customer margin in extreme conditions. The blow-up of the Yuan You Bao product is the concentrated exposure of various risks.

The Yuan You Bao incident has also heightened concerns about banking regulation. Although legally speaking, this kind of product transaction belongs to bank wealth management, but no matter how it is packaged, the futures property of Yuan You Bao is inevitable, it should be managed by the CSRC as a futures product. It needs to be clear that under the current Chinese regulatory system, banks are not allowed to exist as brokers for domestic clients. The participation of banks in overseas futures markets should be jointly supervised by the CSRC, the Ministry of Commerce, the State-owned Assets Supervision and Administration Commission of the State Council (SASAC), and State Administration of Foreign Exchange (SAFE). Some regulators said that the difference between a bank ’s commodity futures trading and an illegal futures exchange that has been hit is that it is not leveraged. A futures practitioner said, "The reason that Yuan You Bao appeared in the banks is that brokers and futures companies cannot be involved in such futures product, and the reason that Yuan You Bao linked to the overseas market is that the banks cannot participate in the domestic futures market." Therefore, it can be considered that these products of various overseas futures trading in the name of wealth management products are in a gray area of supervision, which reflects the contradiction between the separate supervision of China's financial supervision system and the mixed operation of financial institutions.

In fact, from the "New Asset Management Rules" to the establishment of bank financing subsidiaries, the banking sector has been trying to involve in the business of investment banking, capital management, and other sectors. However, different from the traditional credit business of the banking sector, securities issuance, securities investment, fund management, asset management, financial derivatives trading, and other businesses often need more professional personnel and a more complete risk control system, which is exactly what the banking sector generally lacks. On the contrary, the cross-border banking sector brings the flow of credit funds and bank savings funds to the financial market, which breaks through the firewall of the market and further forms the risk diffusion across the market.

In the opinion of the ANBOUND’s researchers, risk control cannot be simply understood as "to observe closely". It actually requires the establishment of systematic institution and professional talents. Now, the cross-market operation of the banking sector means that its risk control system needs to be strengthened. Risk control is the foundation of a bank, as the interest rate is the risk scale, the essence of the banking business is operating risk, which is linked to the risk control. Thus, risk control is the most fundamental foundation in the banking sector. If risk controls prove to be ineffective, the banking sector will be unreliable.

Final analysis conclusion:

The Yuan You Bao incident reflects the Chinese banking sector's poor risk management, and it could be fatal to the entire financial system. "Preventing systemic financial risks" is among one of China’s tasks of this year, and this not only requires paying attention to the credit risk of the banking sector itself, but also the prevention of the spread of banking risks.

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