Shadow Banking, A Menace in China

June 21st, 2011
in Op Ed

money-china Guest Author: Waiching Li (See bio at end of article.)
Note: Article updated on 5Nov.2011
Despite Chinese government's efforts to rein in liquidity by hiking rates and raising the reserve limit to an unprecedented 21%, the consumer inflation index has risen 5.5% over the past year. That level is a three years high, according to figures released by Chinese government on Tuesday.

Follow up:

In China, the persistence of inflation pressure has brought “shadow banking” into a topic of hot debate recently. According to a study issued by the People's Bank of China in 2010, non-banking sector lending has expanded to 6.33 trillion Yuan, ($1 trillion), 44.4% of total lending activities of China's economy.

Shadow banking, a concept coined by the US Federal Reserve, refers to non-banking financial institutions with some banking functions, but they are not or less regulated like a bank. In the U.S., the lack of regulation for the securitization of traditional financial products, including home loans, was one of the major causes of the financial crisis.
Shadow banking in China mainly exists in the form of "Bank and Trust Cooperation", the underground financing networks; but small loan companies and pawn shops also play a role in these shadow financing activities.

While mortgage securitization is not an issue in China, the “Bank and Trust Cooperation” is a vehicle to provide 'hidden' loans to enterprises outside the scope of the bank's reserve limit. Similar to the credit securitization problems in the US, the banks play the role as an intermediary. They charge service fees and commissions for services provided, while referring the securitized loans to banks customers, and raising funds off the bank's balance sheet.
Data released on March 31th, by China Trustee Association, shows that the scale of Bank and Trust Cooperation as has already reached to 1.53 trillion yuan ($0.235 trillion). The risks of such financial arrangements are asymmetrically transferred to buyers. Since no credit ratings are available for these debts, the buyers have to blindly follow the bank's referrals, hoping the banks, which make money from commissions and fees no matter what happens with the loan, have done due diligence and are honest.

Fortunately, unlike the mortgage backed securities that traumatized the US economy, the assets of China's “Bank and Trust Cooperations” are yet to enter the stage of complex financial leverage. Also last January, the CBRC ordered commercial banks to incorporate this type of lending into their balance sheets by the end of this year.

It's a step up to curtail risk, but industry insiders doubt the incorporation process will be completed by the end of this year. They also worry that the increased tightening on banks will further increase illegal underground banking. Unlike the 'Bank and Trust Cooperation', which sits in a legal haze; underground banking, illegal per se, is almost completely unmonitored.

It's estimated by Chinese media that the size of underground banking is in the trillions of dollars. The true number is difficult to determine. Every once in a while, the news reports about a police raid on an illegal financing network gives a glimpse into the ever-enlarging scale of underground banking.

Underground banking gets to thrive on the deficiencies of China's monetary policy. On one hand, the bank's interest rate can't keep up with inflation on the street; on the other hand, cash strapped private businesses can't get loans from commercial banks because state enterprises have a higher priority. Since, in many places, underground banking generally promise at least 5 times higher returns than legal banks, market forces allow the underground banking to flourish.

Shadow banking in China will continue to grow as long as commercial bank lending is unable to meet liquidity demand and interest expectation. However the scale of shadowing banking is undermining the effectiveness of monetary tools to combat inflation. Since last October, China's central bank has raised reserve requirement ratio nine times already, but the inflation pressure still remain high.

Early in May, the Chairman of the China Banking Regulatory Commission, Mr. Liu Ming Kang spoke out at the 22nd committee meeting, claiming that one of the major risks the banking system faces is 'shadow banking'. This is the first time that the CBRC has raised the red flag. Such a statement indicates the increasing uneasiness the regulatory body is having, while trying to engineer a soft-landing.

Related Articles
China's Debt Crisis by Michael Pettis

About the Author
Waiching Li Waiching Li is an independent trader living in Boston. She received a MBA concentrated in Finance from American University and has a BA in accounting from the University of Wisconsin-Madison. She has previous work experience in financial services. Her trading is currently concentrated in the Hong Kong stock market. She frequently visits Hong Kong.

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  1. Derryl Hermanutz, Correspondent (Member) Email says :

    In his GEI article today, Michael Pettis notes that China's shadow/underground banking sector has recently increased monthly interest charges from 1.5% to 5%. Because China's monetary policy is effected "directly" by controlling the quantity of money banks can lend, rather than "indirectly" by manipulating interest rates to encourage or discourage market borrowing; and because banks prefer lending to 'risk free' customers like SOEs and municipal governments and 'favored' customers like real estate developers; China's SMEs are driven into the informal banking sector for loans. And Chinese savers, discouraged by low interest rates paid on formal bank deposits, are driven to fund the lending in the informal banking sector where they earn, according to Ms Li, 5 times as much interest. 

    The first conclusion that springs to mind is that monetary policy is a very 'porous' policy tool. Squeeze here and money simply flows out elsewhere. We had this debate some time ago, arguing the pros and cons of financial regulation, with critics claiming that innovators are always three steps ahead of regulators so regulation is not going to produce the expected effects. China seems to be demonstrating that markets simply flow around regulations that seek to block them. 

    The second thing that springs to mind is the striking similarity of Chinese savers lending to SMEs at usurious if not ruinous interest rates, and yield hungry OECD investors buying unregulated securitized products from Wall St in the pre-Lehman era of Greenspan's low interest rates. When subprime borrowers could not pay they defaulted and we got the 2008 meltdown. How long can China's SMEs function while paying 60%+ annual interest on operating loans?

    Meanwhile, as Michael Pettis observes, China's monetary policy is geared to disguise the insolvency of the real estate and infrastructure developers. 60% interest may be ruinous to a SME, but no more so than building empty ghost cities is ruinous to real estate speculators. 

  2. mh says :

    The author apparently made a mistake converting Chinese notion of numbers to "trillion", which as everyone uses these days equals to 1,000,000,000,000. The "15.3 trillion yuan" is “1.5万亿” in the link (in Chinese). 万 is 10,000 and 亿 is 万 squared (100,000,000). So 1.5万亿 is 1.5 trillion.

    So the "15.3 trillion yuan" should be "1.53 trillion yuan" and "63.3 trillion Yuan" should be "6.33 trillion Yuan". The USD amounts are wrong, too.



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