Shadow Banking In China: The Potential For Financial Domino Effect

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Includes: CHIX
by: Global Risk Insights

Jobs and economic expansion are key goals for China's policymakers. But capital acquisition by firms can be difficult and lead them to shadow banking which may cause serious economic and financial consequences.

China must expand its macroeconomy to provide jobs, keep factories operating, and stay globally competitive. The problem is that many Chinese firms either cannot operate in an efficient and profitable manner or lack financial resources to grow or remain solvent. For these firms, financial capital is severely needed, but fund acquisition is the conundrum. While shadow banking can help these businesses, new problems arise making for an even bigger dilemma.

What is shadow banking?

Shadow banking involves acquiring financial capital in an unregulated environment. This involves non-bank financial intermediaries providing firms loans, which is similar to traditional commercial banking but is actually outside the government's regulatory purview. For example, a clothing manufacturer lends money to an electronics maker without worry of financial regulations regarding collateral or meeting ratio requirements. Small businesses in China can turn to shadow banking for loans when they are in a credit crunch, have exhausted the usual traditional forms of borrowing, or wish to avoid borrowing complications and expenses. On the positive side, shadow banking allows quicker access to financial capital than traditional banking transactions. This also means greater risk to the lender if the borrower has serious financial problems and needs funds to stay afloat while really masking widening financial cracks.

The scale of this issue in China is reflected in Moody's estimates of China's shadow banking industry which stand at $8.5 trillion.

Chinese businesses see shadow banking as a necessary alternative since they are faced with government imposed lending restrictions. These include limits on bank lending imposed by the People's Bank of China (PBOC), a cap of bank loans to deposits of 75 percent, and government regulators discouraging loans to certain industries.

Shadow banking originated due to the 2008-2009 Financial Crisis, when the Chinese government assembled a $586 billion stimulus package with more than 50 percent of the funds available through bank lending. This helped keep China's economy on track for economic growth. Unfortunately, it meant cheap credit for businesses, fueled a speculative housing bubble, kept inefficient state-owned enterprises (SOEs) operating, and eliminated years of Chinese banking financial discipline. The need for credit access grew, increasing China's shadow banking industry. Moody's reports that China's shadow banking grew approximately 30 percent annually for the last three years, while globally the growth rate was 10 percent. China's shadow banking is 80 percent of its GDP, but it is far behind the United States where it is 150 percent of GDP.

Financial implications of shadow banking

China's commercial banks, investment banks, and trust companies are involved in shadow banking by making off-balance sheet loans and leasing arrangements. These are repackaged into financial instruments such as entrusted loans and wealth management products (WMPs) that private individuals can purchase for a higher return than bank deposits. While commercial banks handle lending and deposits, trust companies have more flexibility, combining various elements of banking and asset management. Commercial banks have used shadow banking for loan reclassification of their delinquent loans, as such efforts entail less requirements imposed by regulators than official channels. Here loans have higher default risks even though there is the potential for higher returns. Packaging these risky loans into WMPs or entrusted loans gives commercial banks an opportunity to remove them from their portfolios.

The most popular shadow banking financial product offered to investors and depositors are WMPs which are a portfolio of assets giving investors a return based upon performance. The underlying assets can consist of one large debt obligation or a pool of loans. WMPs are popular with banks and trust companies since they can substitute for bank deposits and depositors are attracted to them for the higher return than other bank products. Investors and depositors assume that the generous return offered by these instruments are guaranteed by the offering bank or trust company.

In essence, investors and depositors are expecting the best of both worlds: higher return than on formal bank deposits and a guarantee by the issuer. The problem is how financially realistic this expectation actually is. Compounding this complicated situation is that WMPs are not regulated and not on the books of Chinese banks. According to the Chinese state news media, investors have placed $4.4 trillion into WMPs; equaling approximately 40 percent of China's GDP.

Entrusted loans are made by large corporations where banks or finance firms act as intermediaries or trustees. Entrusted loans are made either between large firms (either in the same industry, capitalization category) to suppliers or vendors, or customers. The loans are run through banks for legal reasons since the PBOC imposed a regulation in 2000 making it mandatory for a financial institution to facilitate loans occurring between two non-financial businesses. The key here is that banks are protected from the borrower's default risk by the non-financial firm. Entrusted loans also occur when one bank makes a loan to another - an interbank loan. Entrusted loans have become the second largest financing source, surpassed only by bank loans. The amount of newly made entrusted loans achieved a zenith in 2013, when they comprised almost 49 percent of total shadow banking transactions. The problem is that loans may be made on a wink and a nod in order to keep a customer or sole supplier operating. An additional motivation is the future hope that the favor may be returned in the form of an entrusted loan to the original lender.

Need for reform

China's leadership knows it desperately needs to reform the shadow banking industry, since the potential for financial disaster is great. In April 2017, President Xi Jinping admonished top ministers to stabilize China's financial system while the International Monetary Fund (IMF) and Financial Stability Board (FSB) called for immediate reforms and regulations. Both China's leadership and international financial authorities recognize that its financial system is susceptible to greater-than-expected bank losses and a liquidity trap that will be extremely difficult to escape from. While the China Banking Regulatory Commission under Chairman Guo Shuqing has issued directives designed to crack down on shadow banking practices, the real question remains: is it enough?