- Shadow banking in China was first encouraged to facilitate competition.
- It has grown to be the second most important financial sector after commercial banks.
- Chinese regulators are tightening up their oversight.
China is slated to release its latest estimates for banking lending and aggregate financing in the coming days. Over the past 12-months bank lending accounted for about 53% of the total financing, the remainder comes from the shadow banking sector.
In China, shadow banking often refers to the trust companies, which are non-bank lenders. At the end of last year, Chinese trust companies, 68 in all, have almost CNY11 trillion (~$1.8 trillion) assets under management; surpassing insurance companies to be the largest set of financial institutions behind the commercial banks. This is roughly a four-fold increase since 2010.
Trust companies typically raise funds by selling high yielding wealth management products. They use the proceeds to loan to risky borrowers, like property developers, local governments (through their special purpose vehicles), commodity producers, and businesses that banks have been discouraged to lend to, like those identified as suffering from over-investment, like steel.
China's key banking regulator, China Banking Regulatory Commission (CBRC) has reportedly tightened up the rules governing the trust companies. First, the new rules seek to break the Ponzi scheme-like characteristic under which maturing products were paid from new product sales. The CBRC is banning trusts from operating "fund pools". This is the structure by which the fund makes cash payouts on maturing products with the proceeds from new product sales.
Of course, the trusts argue that such "fund pools" allow them to offer higher interest rates because such a mechanism allows a short-term investment to have the payout characteristics of a long-term investment. Most wealth management products have a year or less maturity. Yet the underlying assets are often of a longer-term nature. Often trust companies and banks will borrow money to fund the payout of maturing wealth management products until they have raised sufficient funds from the sale of new products.
A report by a Chinese securities house claimed that almost half of the wealth management products (CNY5.3 trillion) are due to mature this year. An estimated CNY3.5 trillion matured last year. The maturity peak this year is thought to be here in Q2.
Second, the CBRC will require trust companies to develop a contingency plan for if or when a liquidity squeeze is experienced. This includes raising capital from shareholders, suspending or restricting dividends, delaying executive incentive compensation. The fear is that liquidity problems at one trust company could trigger a systemic crisis. Contingency planning is a way to introduce a circuit breaker of sorts.
Third, in order to reduce the chance of a repeat, the CBRC has indicated that it will impose stricter rules on the approval process of new trust businesses and products going forward. Reports suggest that there have been at least 20 trust products that have had faced difficult redemption periods, but none has defaulted. Defaults have been avoided by one of three ways: the issuer, a third party, such as a state-owned (troubled) asset management company, or a firm that offers investment guarantees eventually made the investors whole. Therefore, a default by one of these trust products is unprecedented and represent a new escalation in the official effort to rein in shadow banking activity.
Fourth, the trust companies are required provide regulators with plans by the end of June to unwind the pools of non-tradable assets. This may boost both transparency and liquidity. Trust companies were initially encouraged to foster competition in the financial sector. The problem is too much of a good thing and Chinese officials are making a more concerted effort to rein in it.
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.