Regional Focus

The role of shadow banking

Published: Mar 2014

Warnings about the impact of shadow banking, where non-bank intermediaries effectively carry out traditional banking functions, on the Chinese economy have come from a variety of sources. For example, last July the IMF said it was ‘increasingly urgent’ for China to shift away from its credit-intensive growth model, which it said was ‘not sustainable and is raising vulnerabilities’.

Many analysts and industry commentators have also made their viewpoints clear. Wei Yao, China economist at Société Générale Corporate and Investment Banking, says conditions are ripe for defaults, with slowing credit growth, elevated costs of funding, waning economic momentum and tighter financial regulation. Elsewhere Thomson Reuters refers to the implications of a rebound in China’s average inflation rate, as the government could increase the deposit rate to curb inflation. A higher interest rate would reduce the net interest margin, thereby reducing the amount of funds flowing into shadow banking products and increasing the risk of a funds shortage.

Adding fuel to the fire, Nomura blames shadow banking for deepening income inequality and facilitating wealth transfer from the poor to the rich. Because many products are only available to high net worth retail investors, only the wealthy can take advantage of the implicit government guarantee, while the government will likely have to pick up losses (at least from local government financing vehicle-related investments) using public funds. Industrial and Commercial Bank of China’s recent decision to bail out investors in its ‘Credit Equals Gold No. 1’ investment scheme has added to the sense that savers are effectively being insured against the effects of bad investment choices.

The role of shadow banking in China only appears to be increasing. The Financial Stability Board’s 2013 global shadow banking monitoring report refers to a 42% increase in assets of ‘other financial intermediaries’ in China in 2012. According to analysis from Crédit Suisse, core Chinese shadow banking products were worth RMB 22.8 trillion ($3.72 trillion) at the end of 2012, accounting for 44% of GDP and half of all new credit issued. Crédit Suisse likens some of these shadow banking products on offer to the collateralised debt obligations offered in the US before the financial crisis, albeit without established regulation and with even less surveillance.

A positive role?

However, a document circulated by the Chinese government in December refers to the emergence of shadow banks as an inevitable result of financial development and innovation and says that as a complement to the traditional banking system, shadow banks play a positive role in serving the real economy and enriching investment channels for ordinary citizens. The document also states that ‘at present’ the country’s shadow banking risks are under control, although guidelines from the State Council call for tighter regulation of banks’ off-balance sheet lending and say that trust companies – the biggest non-bank players – should return to their original purpose as asset managers and not engage in ‘credit-type’ business.

In a new report on the sector, XTEChina Consulting principal Tim Summers states that shadow banking probably does not pose a big threat to public finances right now, but that it may become a source of systemic risk if its rapid growth continues. “The main risks resulting from shadow banking are liquidity risk due to maturity mismatch, credit default risk from loans to weaker companies or projects and the exacerbation of already high corporate overstretch as shadow banking helps plug cash holes. There are few tools available to clearly identify or quantify these risks,” says Summers.

He warns that while part of the demand for informal lending reflects growth potential from innovative or emerging companies, it also reflects a deteriorating environment for at least some corporations in China. “Cash flow pressures for many Chinese companies have grown over recent years. This means a growth in demand for credit, whether to invest in new capacity in an effort to grow out of crisis or simply for bridging loans to help manage cash shortfalls.”

The shadow banking sector provides at best short-term benefit to borrowers who cannot obtain funding from the conventional banking sector for them to buy time to avoid a liquidity crunch, says Peter Wong, founding chairman, International Association of CFOs and Corporate Treasurers (China) and convenor, Hong Kong Association of Corporate Treasurers. “Lenders/investors and financial intermediaries are not assured a sustainable return as borrowers face very high interest costs. The social and economic costs for misallocation of capital will likely outweigh short-term expansion in loss-making fixed asset investment.”

Wong expects increased competition resulting from interest rate liberalisation and deleveraging to force banks to apply sound credit risk management to improve lending margins. “In addition, development of the capital market – including reopening the A-shares IPO; promoting the RMB corporate bond market (especially the high yield segment); and increasing the role of professional/institutional investors will provide the much needed long-term funding and reduce the refinancing risks of bank loans.”

Chasing shadows

One of the key questions going forward is whether Chinese regulators have the resources to properly police the shadow banking sector. Wong observes that there are already restrictions on shadow banking loans disguised as wealth management products, with banks distributing such off-balance sheet products facing reputational risk and compliance risk of misrepresentation as well as potential sanction by the China Banking Regulatory Commission (CBRC). “Other shadow banking lenders will be discouraged by a deteriorating credit outlook and will find it harder to obtain cheap funding in a tight money supply situation,” Wong adds.

“The process of forcing the state-owned banks to increase their lending to businesses may take longer to achieve as they enjoy certain legacy advantages not accessible to smaller banks or newcomers, such as a sizeable deposit base from state-owned enterprises, lower funding costs with implied government support and comprehensive location coverage nationwide,” he continues.

In early January 2014, the CBRC said it would implement a limited licence regime and set up three to five private banks on a trial basis in an effort to deepen reform in the domestic banking sector. It also said that it would explore lowering the threshold for foreign banks to enter the industry.

“The intention is for the new privately financed banks to fill some of the gap left by reduced shadow banking activity, although certain conditions will need to be put into place including a credible nationwide deposit insurance scheme, further development of the wholesale funding market and improved connectivity and accessibility of multi-bank ATM networks,” Wong acknowledges. “That will provide a much more level playing field to newcomers on sourcing funds and service delivery.” As an economist at the Manufacturers Alliance for Productivity and Innovation (MAPI), which is focused on increasing productivity and innovation in manufacturing, Yingying Xu is well placed to comment on the impact of shadow banking on commercial enterprises doing business in China.

She explains that shadow banking initially boosted export activity because most exporters are small- and medium-sized private businesses and the state-owned banks are mandated to lend to large businesses and state-owned enterprises. “It is only in the last three to four years that the exponential growth of this type of lending to local government (for infrastructure construction) has started to cause concern.”

The issue that has made the largest contribution to the growth of shadow banking in China is the cap on lending and savings rates, which is controlled by the central bank. The state banks will not lend to small businesses because they cannot charge them higher rates than large corporations who have a lower risk profile. Therefore, small businesses have to rely on informal lending for financing, for which they pay higher interest rates – which attracts funding from both formal financial institutions and savers.

“Savers have limited investment options,” says Xu. “The stock market has been depressed for several years and is blighted by insider trading, which has destroyed public confidence, so savers are looking to channel their investments into the informal lending sector.”

“Stronger supervision and regulation will help to contain shadow banking in the short term and will not necessarily have a direct impact on formal lending. But to solve the root cause will need more radical policy change (such as interest rate liberalisation) and that can impact formal lending.”

Reform needed

It has been suggested that Chinese regulators might be given additional resources to properly police the shadow banking sector, but Xu notes that the central bank has moved more rapidly over the last 12 months to liberalise the financial sector, for example by allowing the larger banks to relax the lending rate cap, ending the lending rate floor and allowing the inter-bank rate to be determined by markets.

“However, if the government maintains caps on lending rates and subsidises loans to state-owned enterprises there is no incentive for the banks to lend more to small businesses. One of the major elements that is missing from the liberalisation agenda is reform of state-owned enterprises.” Privately financed banks would probably have more control over the interest rates they charge, but they would not address the problem of interest rate caps within the state banks, she adds.

“Without meaningful reform on liberalisation of interest rates, private banks wouldn’t be able to charge higher rates to riskier borrowers and wouldn’t be able to compete on a level playing field with state-owned banks to attract savings either. The Chinese banking system does not currently allow for proper risk assessment and it is unclear what regulations the privately financed banks would have to comply with. There is risk assessment in state-owned banks, but it is still at an early stage of development.”

According to Chris Devonshire-Ellis, Chairman of Dezan Shira & Associates (which provides tax advice to foreign direct investors across Asia), a local government default this year would not be a surprise and he also refers to similar concerns around some of the smaller local banks. “We have seen this before. The government of Guangdong defaulted on its Guangdong International Trust and Investment Corporation vehicle in 1999 leaving investors (many of them foreign) out of pocket to the tune of $4.4 billion. Beijing refused to bail them out and I can see this happening again.”

He is not convinced that shadow banking has produced any benefits to the Chinese economy. “While it is true that financing has been obtained, much of it is at high rates and I suspect much of that credit has gone on vanity projects and ‘white elephant’ infrastructure. China has a massive property bubble as a result and while the Chinese have continued to target and measure in simple GDP growth terms alone, this has led to many local governments and even state-owned enterprises investing in pointless projects just to keep their GDP rates high and at targeted performance levels.”

Devonshire-Ellis claims that limiting the growth in loans created outside formal channels without significantly affecting the flow of credit into the economy can only be achieved at a cost. “This will manifest itself by institutions such as local government funds and trusts (as well as some banks) going to the wall. That will be a wake-up call that financing has to be provided by state channels, but the issue here is that even these are notoriously inefficient. China needs to liberalise its banking and financial sectors to sort this out, so there needs to be a dual effect – some sharp and painful lessons followed by reforms.”

He believes China will appear rather less capitalist by the end of this year, but this does not mean that the state will automatically pick up the bill. “The people who invested in schemes like ‘Credit Equals Gold No. 1’ are wealthy Chinese – I think the Communist Party of China will just tell them to swallow their loss. If they complain they will likely face investigation as to how they accumulated their wealth. So the party will nip protests in the bud and blame a few corrupt bankers, businessmen and officials in the normal manner.”

Devonshire-Ellis says increasing business lending by state-owned banks will require reforms at state-owned enterprise-level as well as in the financial and banking sectors. He expects the government to use what will be a messy period as an excuse to push through reforms in the wake of what he believes is going to be a series of bankruptcies during 2014, although these will be restricted to smaller banks and governments. “Then they will have a reason to push through the reforms that to date they have only been talking about. It will be a fait accompli by the reform faction over the traditional hardliners with their vested interests.”

He is not optimistic that privately financed banks will become a major force, although it is possible that reforms and mergers could lead to the creation of some larger banks from what have until now been relatively small players. He also expects to see foreign governments or even banks take equity positions in some of these new institutions.

“I don’t expect the CBRC to lower the entry threshold for foreign banks, but I do expect it to reform market entry and what these banks can do. This would also extend to insurance companies – China desperately needs to get its welfare system onto an insurance-based model and this will be part of any financial reforms, quite apart from the banking sector and easing out all that bad credit and failed schemes.”

An alternative source of finance

In addition to the property sector, shadow banking has been utilised by industries with excess capacity (including coal mining and steel) as such businesses have faced difficulties getting loans from the formal banking system, explains Wang Ming, Director of Shanghai Yaozhi Asset Management. “The financial sector may be the most ‘damaged’ as shadow banking comes with notable default risks. The rescue of investors in the high yield trust distributed by Industrial and Commercial Bank of China to fund a family-run coal miner is a fresh warning.”

Ming believes that it will be hard for the government to limit the growth of shadow banking as such a move would be very likely to seriously affect the property sector and slow down China’s economic growth significantly. “Privately financed banks could fill a small part of the gap left by shadow banking, but I don’t think they could do a lot since sectors financed by shadow banking commonly face larger default risks and the new banks are unlikely to ignore these risks.”

He describes lowering the entry threshold for foreign banks as a long-term target for the CBRC. “I don’t think such a move could take place this year or next, as the regulator needs to protect small banks (including the new privately financed banks) from competition from more experienced foreign banks.”

Despite the dire warnings, it appears that shadow banking will remain a significant component of China’s financial system for the foreseeable future. The authorities appear content to maintain current levels of lending, so the challenge for its practitioners will be to stay one step ahead of the regulators to deliver useful financial innovation while seeking short-term profit through regulatory arbitrage.

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