Creating a Valuation Model to Manage Investment Risk
In recent developments within the financial sector, there has been a notable shift as banks' asset management subsidiaries embark on testing their own bond valuation models. This initiative has sparked attention across the market, as stakeholders weigh the potential implications of institutionally-developed valuation frameworks amidst varied opinions.
Feng Jianqiao, the general manager of Hesheng Assets, has voiced concerns regarding these new models, suggesting that if the sole aim of establishing such systems is to minimize fluctuations in net asset values, then it would be prudent to adopt a shadow valuation approach based on the China Bond valuation or the China Securities valuation as benchmarks. He argued that adjustments should only be made when deviations exceed a predetermined threshold, and such modifications must be promptly reported to regulatory authorities.
The Need for Stabilized Returns
As these newly constructed bond valuation models undergo internal testing, the objective remains clear: to mitigate the shocks associated with volatile valuations that impact net asset values of financial products. An asset management professional from a prominent joint-stock bank voiced that this move is critically aimed at curtailing the fluctuations in valuations that are impactful to the net worth of various financial products.
This situation is particularly vital for individual investors. According to experts, one of the standout features of bank wealth management products has been their reliable and stable performance. Since the implementation of new asset management regulations, a comprehensive transformation towards net-value management has reinforced the allocation of deposits and bond assets, thereby enhancing the stability of net asset values. However, the turbulence in capital markets over the past couple of years and subsequent reductions in deposit rates have exacerbated volatility in net asset values, leading to an increase in occurrences of fixed-income products experiencing depreciation.
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A recent analysis by Huafu Securities highlighted that following the 2022 shift towards total net-value management in bank wealth products, fair value accounting began overshadowing amortized cost accounting as the primary means of valuation. In this context, market value approaches were generally employed, often relying on third-party valuations. For inter-bank bonds, evaluations typically utilized Zhongzheng valuations, while exchange-traded bonds leaned towards Zhongzheng benchmarks. Nonetheless, the reliance on external valuation services has also been contentious, especially during the market volatility witnessed in November and December 2022, which was implicated in amplifying bond price fluctuations. This situation necessitated the adoption of mixed valuation methods to stabilize fund inflows into wealth management products.
Asset management firms have consequently initiated the establishment of new valuation systems, specifically designed to smoothen the net asset value curves of their financial products. According to recent research released by Everbright Securities, the trend in bank wealth management is set to continually face the challenge of seeking certainty amidst uncertainty. Beyond existing mechanisms that leverage the lack of consistency in interest rates between deposit curves and market curves, any additional measures aimed at enhancing or stabilizing returns, particularly in competitive scenarios against other non-bank entities, will invariably require the application of distinct methodologies, including possibly the self-built valuation model.
The economic research team at Guosen Securities has further elaborated on the importance of self-constructed valuation models, highlighting that prior to this, banks often relied on alternatives like fund segregations or trust arrangements to smooth earnings while maintaining stability in liability management. However, recent regulatory corrections have begun to confine those options, compelling wealth management firms to confront net asset value fluctuations more directly—with intensified focus now being placed on the potential of self-built valuation models.
Current testing efforts into self-constructed models by wealth management firms are notably centered on bond-related assets, particularly on subordinated perpetual bonds issued by banks
Why prioritize bonds in the construction of these valuation models? Many market participants argue that since a significant proportion of wealth management products are invested in fixed-income assets, developing robust valuation systems specific to bonds is deemed essential for maintaining the stability of net asset values.
According to the latest half-year report from the China Banking Wealth Management Registration and Custody Center, as of June 2024, the balance of wealth management products directed towards bond assets amounted to approximately 16.98 trillion yuan, accounting for a remarkable 55.56% of all invested assets.
In practical terms, analysis by Everbright Securities suggests that standard bond assets such as government bonds often utilize third-party valuations provided by Zhongzheng or Zhongcai; however, issues arise specifically with bank capital bonds where existing third-party models might be obscured by lack of transparency in parameter adjustments and significant price volatility around certain critical dates.
Concerns surrounding the reliability of third-party valuations have prompted some wealth management institutions, taking inspiration from similar practices used for preferred stock—another form of capital supplement—to initiate their own yield-based evaluations for subordinated perpetual bonds, often facilitated through channels provided by trust companies.
Yet, while self-built valuation models promise to yield certain advantages, they are not devoid of challenges. The Guosen Securities banking team has pointed out that various methods employed to curtail net asset value volatility come with distinct advantages and disadvantages. The gradual cessation of smooth fund approaches indicates a potential for the self-valuation method to see more widespread application, while actively adopting asset hedging techniques could also expand opportunities.
Outstanding Liquidity Risks
Nonetheless, there remains a significant debate among market commentators regarding the actual effectiveness and risk implications of self-built valuation models in stabilizing returns.
The economic research team at Guosen Securities has noted that while self-built valuation frameworks exhibit strengths in achieving smoother returns and are readily acceptable within regulatory frameworks, they may also face pitfalls with respect to negative deviations and potential trust issues surrounding the credibility of the models.
However, representatives from certain urban commercial banks have expressed a leaning towards utilizing third-party valuations, citing the accessibility and convenience of existing models provided by Zhongzheng and Zhongcai. The efficacy of self-constructed systems in actually diminishing volatility ultimately hinges on the underlying logic of the model itself and how it measures up against existing benchmarks, particularly regarding the weightage assigned to various volatility factors.
From a valuation perspective, Feng Jianqiao has articulated that in instances where liquidity is robust—such as with highly liquid stocks—the market price tends to be the definitive valuation reference, as alternative methods could introduce substantial moral hazards. He underscores the notion that the more management engages in pricing counsel, the poorer the fairness of valuations becomes, increasing the moral risks and consequently exacerbating long-tail risks. Given bonds inherently lack strong liquidity, Feng stressed that both Zhongzheng and Zhongcai likely have adequately integrated market pricing influences into their valuation models, ensuring a balanced and relatively fair assessment.
There are also warnings about liquidity risks associated with the newly adopted models for subordinated perpetual bonds. Analysts at Western Securities believe that in the short term, the self-valuation approach could positively impact subordinated perpetual bonds, potentially leading to increased allocations in wealth management products; however, the long-term consequences on the liquidity of these instruments remain to be seen, especially if valuation smoothing undermines liquidity.
Furthermore, Everbright Securities points out that in periods of rapid adjustments in market interest rates, third-party valuation adjustments tend to be more responsive. This potential lag in self-valuation could create misalignments, heightening redemption pressures from institutional clients holding financial products as discrepancies in valuations amplify during large-scale withdrawals. The uncertainty of how to correct valuations during instances of divergence remains a crucial point of contention within the design of these self-built models.
Additionally, it is crucial to recognize the uncertainties accompanying the extensive implementation of self-constructed valuation systems. Analysts from Western Securities have indicated that, from a regulatory standpoint, authorities may impose stricter requirements regarding the transparency and prudence of these models in a bid to maintain market stability and safeguard investor interests. There's also the market’s acceptance aspect—investors are likely to remain vigilant towards the deviations between modeled prices and market prices, along with the resulting risks in measurement discrepancies.
Finally, Everbright Securities has underscored the necessity for regulators to clarify their stances on self-valuation moving forward. This could entail explicit specifications on methodologies, applicable scopes, and parameters for deviation adjustments.