Shadow banking, led by corporates, is making an unwelcome resurgence in China.

A few years ago, shadow banking and the negative connotations associated with this was a hot topic in discussions about China.

The risk posed by the sector and the non-bank intermediaries that effectively carry out traditional banking functions, particularly offering credit, was seen by some to hold the makings of the next great financial crisis.

Yet, this doomsday scenario didn’t occur, and shadow banking began to fall away from the headlines, as Chinese regulators focused on policing the industry. This was until late last year, however, when a number of reports emerged detailing that shadow banking in China was making a comeback.

One product, in particular, was continually mentioned: entrusted loans.

Peer to peer

Entrusted loans, according to BMI Research, is one of the fastest growing segments of the shadow banking sector.

These loans are made from one corporation to another with a trustee or agent (like a traditional bank) acting as an intermediary.

“The companies involved in entrusted loans are typically large state-owned enterprises (SOEs) with excess cash,” says Grace Wu, Senior Director, Financial Institutions at Fitch in Hong Kong.

“Previously these loans were usually provided to subsidiaries/affiliates, similar to intercompany loans seen elsewhere around the world, but in more recent years these are increasingly being used to lend to unaffiliated companies.”

The reason being that it can prove to be a profitable business for these companies, especially if their core business is struggling through overcapacity or the slowdown in the Chinese economy – as has been the case recently.

And if there is a lot of cash on the balance sheet it seems a logical move to make. “SOEs enjoy greater access to bank financing, and they lend out money to smaller companies – often those who are denied formal bank loans – to improve returns,” says Wu.

Indeed, a study by the National Bureau of Economic Research highlighted that between 2007 and 2013 more than 60% of entrusted loans were channelled to companies in industries with overcapacity.

Default danger

It is a strategy not without its risks, however, because as Wu explains, “the borrower default risk lies with the issuer”. And with defaults rising in China, the risk is only increasing

The Wall Street Journal, for instance, recently reported that one state-owned energy company was writing off US$8bn of its US$10bn portfolio of entrusted loans made a to small coal companies.

The ability then of these firms to conduct prudent due diligence and understand the risks associated with making these loans is crucial. And BMI research believes, according to a recent report, that many of these companies “do not have the expertise to operate like a bank and evaluate the creditworthiness of the lender” meaning that many loans will become non-performing as the economy slows further.

Debt on debt

With China’s bad corporate debt problem already under the microscope and shadow banking seemingly making an unexpected resurgence, fears are increasing that serious trouble is on the horizon.

Last year, David Lipton, First Deputy Managing Director, IMF said: “Corporate debt remains a serious — and growing — problem [in China] that must be addressed immediately and with a commitment to serious reforms.”

He went on to warn that “company debt problems today can become systemic debt problems tomorrow. Systemic debt problems can lead to much lower economic growth or a banking crisis. Or both.”