Chinese banks are starting to create a web of risk through their wealth management products (WMPs), raising concerns about the health of the financial system just as China's economic growth has slowed to its weakest pace in 25 years.
Retail investors are the majority of buyers of WMPs, which offer higher interest rates than a bank deposit. But it isn't always clear what assets the funds are buying to finance those payouts. The industry publishes aggregated data on where WMPs tend to invest, but the disclosures of individual products can be vague. Overall, WMPs tend to invest in the industrial sector as well as industries related to local government and real estate, according to Fitch.
All of these are segments of the economy suffering from overcapacity.
Most WMPs -- as many as 74 percent -- don't carry the issuing bank's guarantee that investors will be made whole at the end of the product's term, which is usually less than six months, Fitch said. But even if the products fail to meet performance expectations, banks may choose to repay investors anyway to avoid the spectacle of mom and pop protesters in front of its branches -- something that occurred outside a Hua Xia Bank branch near Shanghai in 2012, according to a Reuters report.
When the WMP's performance isn't up to snuff, it can become a risk for more than just the issuing bank.
"The fear is that investments are in industries that might not be generating cash so when they come due, the cash to repay investors might not be there. There's always pressure to roll them over," Jack Yuan, associate director for financial institutions at Fitch, said last week.
Additionally, some banks are investing in other banks' WMPs -- those investments are usually on banks' balance sheets in a category called "investments classified as receivables," Yuan noted.
"There are a lot of interlinkages in the banking sector in terms of banks investing in other banks' WMPs and calling on the interbank market for funding if they do go bad," he said. "It's going to be more and more difficult to resolve these if they do go bad."
There were around 23.5 trillion yuan ($3.60 trillion) worth of WMPs outstanding at the end of 2015, up from around 15 trillion yuan a year earlier, Fitch noted, with around 3,500 new ones offered each week.
Banks aren't entirely ignoring risks. Payouts have been coming down, with the weighted average of closed-end WMPs yielding 4.68 percent at end-2015, down from 5.06 percent in 2014, according to Fitch data. That gives banks some breathing room if assets in WMPs don't perform as planned.
Fitch isn't alone in seeing risks to ties between banks.
Standard & Poor's (S&P) also sees red flags related to the WMPs. In a research report published in January, S&P noted that China's corporate bond prices have surged.
"The strong bond performance has led to a surge in leveraged debt investment positions that are ultimately funded by the banks' interbank exposures and WMPs. But nobody really knows how levered these positions are, who has financed them, and by how much," S&P said. "The contagion risks for the financial sector could be high."
It noted that interbank funding was around 14.5 percent of China banks' total balance sheets by the end of November of last year.
S&P has an overall negative outlook for China's banking sector, saying "the ingredients for a credit downturn in China's banking sector are coming together."
Follow CNBC International on Twitter and Facebook.
—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1
