China has issued stricter guidelines governing trust firms, two sources with direct knowledge of the rules told Reuters on Monday, in a bid to counter systemic risks posed by the biggest players in the country's shadow banking sector.

Trust companies are non-bank lenders that raise funds by selling high-yielding investments known as wealth management products (WMPs) and use the proceeds to fund loans to risky borrowers such as property developers, local governments and others to whom banks are reluctant to lend.

The new rules from the China Banking Regulatory Commission (CBRC) aim to reduce liquidity risks associated with off-balance-sheet WMPs by forbidding trusts from operating so-called fund pools that enable them to fund cash payouts on maturing products with the proceeds from new WMP sales.

The latest guidelines appear consistent with regulators' overall approach to shadow banking, which has become an important funding source for weak borrowers.

Policymakers have encouraged the rise of non-bank lending as a means to diversify China's bank-dominated financial system, while issuing targeted rules to curb the riskiest practices.

The guidelines also require trust companies to develop clear mechanisms for shareholders to provide emergency support to the trust firm during periods of liquidity stress.

Regulators are concerned that liquidity problems with a single trust product has the potential to ignite systemic risk, said a trust industry executive who has seen the document. He said the document signals that liquidity risk will be a key focus for regulators this year.

"Fund pools" refer to pools of cash and credit assets from various different WMPs that banks and their trust company partners maintain.

Regulators have increasingly focused on such structures over the last year, targeting the liquidity risk posed by the practice of using proceeds from the sale of new WMPs to finance cash payouts on maturing products. China's securities regulator has compared this practice to a "Ponzi scheme."

Regulators want trusts to strictly match each WMP with a specific set of underlying assets, rather than pooling cash and assets from different products together into common pools.

Trusts face pressure to use fund pools because doing so allows them to offer more attractive yields on the WMPs they sell. Such products typically carry a maturity of a year or less.

Reuters