China’s Stock Crash Is Spurring a Shakeout in Shadow Banks

China has been struggling to tame its shadow banks for years. Now, a stock market crash has hamstrung some of the fastest growing ones in a matter of weeks.

Loans from sources such as online lenders for equity purchases have plunged by at least 700 billion yuan ($113 billion), a drop of 61 percent from this year’s peak, after authorities banned them from funding stock buying in July, according to a Bloomberg survey conducted last month. Peer-to-peer Internet lending for the purchases had more than tripled to 8 billion yuan in the second quarter, data from research firm Yingcan Group show.

The reversal has helped cull riskier lenders in China’s online market, which was surging before the equity rout wiped out more than $4 trillion. President Xi Jinping has already curbed traditional forms of unregulated funding -- such as trust loans -- as part of his effort to wean the economy from debt-fueled growth after corporate defaults mounted.

“The new regulations are making the industry more disciplined and transparent,” said Wei Hou, a senior equity analyst for Chinese banks at Sanford C. Bernstein & Co. “There may be short-term pain of a number of small players closing down. But it’s good for the industry in the long term.”

New Rules

Peer-to-peer lending was pioneered in the U.S. by companies such as LendingClub Corp., but China is where it’s really taking off. Origination of such loans totaled the equivalent of $41 billion in 2014 and will exceed $332 billion by 2017, according to Maybank Kim Eng Securities Pte. That compares with only $6 billion in the U.S. last year.

While China’s benchmark Shanghai Composite Index rose 2 percent Friday as of 2:50 p.m. in Shanghai, it remains down 28 percent from its high for the year marked in June.

The China Securities Regulatory Commission said on July 12 that it would stop online sites from handing out loans for share purchases. Internet finance firms will need approval from financial as well as cyberspace regulators, the People’s Bank of China said on July 18.

Zhongxin Quick Loans, a lender to companies and individuals in the eastern province of Jiangsu, said last month it’s liquidating assets because borrowers can’t repay loans and investors are demanding their money back. Bangcheng Financial, another online lender based in the southern province of Fujian, said it’s restricting redemptions for investors who offer loans on its site after too many tried to cash out.

Whack-A-Mole

“Chinese regulators realized how many risks stock financing had brought,” said Zhu Mingchun, founder of Yingcan Group in Shanghai. “P2P sites that focused on stock finance will change their focus back to smaller company funding -- what the government originally wanted such lending to serve.”

China’s government-backed banks are limited by interest rate controls and pressure to lend to large state-owned enterprises, prompting expansion of shadow lending that Moody’s Investors Service estimates reached 41 trillion yuan at the end of 2014.

“There is little control in place to ensure quality of lenders and borrowers on some of these platforms,” said Barry Lau, a managing partner at Adamas Asset Management HK Ltd., which manages about $630 million.

While the shadow-banking industry can help channel funds to productive businesses, the rise in new kinds of financing tied to the stock market flags the difficulty regulators have managing risks, said Stephen Schwartz, a senior vice president of credit policy at Moody’s. “There’s always a new form popping up when regulators crack down.”

Chinese shadow banks’ push into Internet finance comes as the slumping real estate industry, which accounts for about a third of the economy, demands less cash. The lenders’ business with local governments has also suffered as President Xi rolls out municipal bonds they can go to instead for financing.

“Funding demand for the property sector and local government financing vehicles has come down,” said Liao Qiang, a banking analyst at Standard & Poor’s in Beijing. “The golden days for shadow banking lenders with high return and low risk are over.”