A Primer On Chinese Shadow Banking

by: Christopher Balding

Note: This is the first part in a series on Chinese banking, shadow banking, and finance.

Since the "discovery" of the shadow banking sector and hiccups in the Chinese economy the past few weeks, commentators have hurriedly been writing pieces to fill a void that make significant errors. Conjuring up images of back-alley deals and seedy loan sharks, there is an enormous amount of misinformation about the shadow banking sector. For instance, The New York Times believes that this is driven primarily by "…less regulated part consisting of high-yielding wealth management products…". The Atlantic claims shadow banking as $2 trillion USD in assets, while the NYT says it is around $6 trillion USD. J.P. Morgan, which has produced the most detailed study, also produces an estimate of around $6 trillion USD, equal to 70% of Chinese GDP. Beyond the obvious factual and analytical inconsistencies, there are serious deficiencies about the Chinese economy, banking in general, and shadow banking.

Shadow banking isn't in the shadows.

Despite the well-chosen and catchy name, shadow banking isn't in the shadows. First, the shadow banking industry is driven by the largest banks in China, which are owned by the government through Central Huijin Investment, a subsidiary of the China Investment Corporation (CIC), reporting to the State Council of the Peoples Republic of China. The new Chinese minister of finance, Lou Jiwei, came from the CIC, which essentially owned a controlling stake in every major bank in China. Nine of the top 10 banks in China are state-owned. The major state-owned banks in China control nearly 60% of deposits, with local government banks responsible for most of the remainder.

These are not shadowy corporations owned by gangsters, but are directly controlled by the government. These are the largest and most dominant banking government-sponsored groups in China, and most definitely not in the shadows. These activities are approved of by the government and not some mistake that grew without government knowledge. This evolution in Chinese banking has been at the very least tacitly approved by the highest reaches of Chinese government. Second, it is simply misinformed to call a banking sector with approximately $6 trillion USD under management a shadowy enterprise. In an $8 trillion nominal economy, $6 trillion just isn't in the shadows. J.P. Morgan, which has produced the most detailed, cited, and replicatable data on shadow banking in China, finds that it is 36 trillion RMB and doubled from 2010 to 2012. As news report after news report notes, shadow banking products are being sold by the largest banks, and are worth nearly 70% of Chinese GDP. The only reason it is called shadow banking is because it sounds cool, with a catchy, semi-nefarious nickname.

Chinese shadow banking is and isn't any riskier than normal banking, but not for the reasons you think.

There is this idea that shadow banking, merely by its slightly sinister name, must absolutely be riskier. Yes, but also decidedly no. First, there is currently no such thing as deposit insurance in China. There is no formal protection or guarantee of bank deposits in China. There is the belief or expectation that the government will bail out banks that go bust, but that is very different than anything like a legal guarantee or deposit insurance. Wealth management products (WMPs) sold by the same banks have the same implied guarantee. Consequently, wealth management products for depositors are little different guarantee-wise than straight deposit savings. In fact, to date, WMP quasi-defaults have all been backstopped in some manner. The distinction between WMPs and deposits is legally and realistically minimal. Beijing is concerned with the political implications of causing a bank run, not the legal differences of guarantees on WMPs versus bank deposits.

Second, WMPs sold by banks are generally drawn from their books of loans, because there is not a bustling secondary debt market and essentially no securitized or CDO market. The corporate bond market is woefully underdeveloped, reserved nearly exclusively for the major state-owned giants that are viewed as having a state guarantee. To put the size of the corporate bond market into perspective, despite having an economy that is seven times larger than South Korea, the Chinese bond market is only 24% larger. Viewed from another perspective, the Chinese corporate bond market as a percentage of GDP is one of the smallest in the region -larger than only Vietnam, the Philippines, and Indonesia. China only exceeds them because their corporate bond markets represent only 0.7%, 4.9%, and 2.3% of GDP, respectively. This means that banks in China are selling WMPs that come primarily from their own loan portfolios. Though banks may work with quasi arms-length trust companies to sell WMPs, there is not what we think of as a bustling secondary market with any credit analysis of the underlying asset. There is not the widespread ability to bundle or securitize loans and pass them on in the way most are familiar, with respect to the sub-prime crisis in the United States.

Third, and this is where the risk enters, depositing funds with a bank gives risk diversification to the depositor across all their loans, while a WMP holds a much smaller and self-selected (self being bank) pool of loans. In other words, depositing funds with a bank bets that the Chinese government won't let a bank go bust, while buying a WMP bets the government probably won't be willing to let a smaller pool of wealthy Chinese lose money if a WMP goes bust. This essentially turns Chinese banks into a slight variation of the originate-to-distribute model, but without any formal risk management or securitization, though US ratings agencies and investment banks didn't seem to interested in guarding against credit risk. Extensive research on the US crisis shows that banks using the originate-to-distribute model "originated excessively poor quality" loans and "did not expend resources in screening their borrowers (PDF)." One estimate found that the loss was quite significant with loans sold in the secondary market "suffer[ing] value destruction of about 15% (PDF)". It goes without saying that Chinese banks probably aren't moving their highest-quality loans into off-balance-sheet WMPs, though there is no systematic evidence on this, as this data is quite literally a state secret.

There is one additional uniquely Chinese characteristic to WMPs as compared to the subprime crisis. In the United States, securitized loans were bundled and sold on to institutions that should have known how to value assets and risk. In China, WMPs are sold directly to consumers by banks and other financial institutions like trust companies. The consumers attribute the same riskiness to the WMP as they do to bank deposits with that bank, even though that is not financially accurate. This makes any political fallout that much more explosive. In other words, it is consumers and not institutions bearing the risk of dubious credit quality loans in the Chinese bubble.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.