The central bank is trying to rein in risks.

Photographer: Brent Lewin/Bloomberg

The Shadow Looming Over China

Christopher Balding is an associate professor of business and economics at the HSBC Business School in Shenzhen and author of "Sovereign Wealth Funds: The New Intersection of Money and Power."
Read More.
a | A

Of all the topics sure to be come up in Sino-U.S. economic talks this week -- from the problem of excess capacity to currency controls -- the health of China’s financial sector will no doubt feature high on the list. Especially worrying are the multiplying links between the country's commercial and “shadow” banks -- the name given to a broad range of non-bank financial institutions from peer-to-peer lending platforms to trusts and wealth management companies. All told, the latter now hold assets that exceed 80 percent of China’s gross domestic product, according to Moody’s -- much of them linked to the commercial banking sector in one way or another. That poses a systemic threat, and needs to be treated as such.

There’s nothing inherently wrong with shadow banks, of course. Largely owned by the government, China’s commercial banks focus primarily on directing capital from savers to state-owned enterprises, leaving Chinese households and smaller private enterprises starved for funds. Shadow banks have grown to meet the demand. At their best, they allocate capital more efficiently than state-owned lenders and keep afloat businesses that create jobs and growth.

QuickTake Shadow Banking

The line between good shadow banks and dodgy ones is increasingly fuzzy, however, as is the divide between shadow and commercial banking. Traditional banks often assign their sales teams to sell shadow products. This gives an unwarranted sheen of legitimacy to schemes that are inherently risky. Buyers trust that the established bank will make them whole if their investment goes south.

Shadow banks are also selling more and more products directly to commercial banks. Wealth management products held as receivables now account for approximately 3 trillion yuan of interbank holdings, or around $500 billion -- a number that’s grown sixfold in three years, as Bloomberg Gadfly’s Andy Mukherjee pointed out recently. According to Autonomous Research, as much as 85 percent of those products may have been resold to other shadow banks, creating a web of cross-ownership with disturbing parallels to the U.S. mortgage securities market just before the 2008 crash. In total, the big four state-owned banks hold more than $2 trillion in what’s classified as “financial investment,” much of it in trusts and wealth-management products.

Some smaller banks even seem to have adopted the risk-taking approach of shadow bankers. Although banks are no longer required to lend only at official (and artificially low) rates, they tend to do so anyway. Some buy wealth-management products instead to achieve higher rates of return. As a bonus, they can record the risk weighting of these “loans” to financial institutions at pretty much whatever they want, rather than the 100 percent weighting assigned to traditional loans.

The potential for disaster is significant. In a country with no credit reporting bureau and many doubts about the enforceability of contracts, wealth-management products aren’t for the faint of heart. Online peer-to-peer lending platforms give little thought to the creditworthiness of borrowers; several have collapsed in the past year. The sector has earned such a bad reputation that one platform felt it necessary to employ the motto, “Honestly, we won’t run away.”

Given that most shadow lending is short-term in nature, typically under three months, there’s a risk that a small-scale panic could rapidly turn into a liquidity crisis that sweeps the industry. And liquidity crunches are the drivers of financial crises. The increasing ties between shadow and commercial lenders raise the risk of spillover into the larger financial sector.

The government appreciates the threat and has taken some initial steps to rein in risks, forcing banks and asset managers to recognize their loans and risky capital differently. However, Chinese financial engineers have proved adept at creating new structures and products to keep a step ahead of regulators. The government’s unwillingness to push borrowers to deleverage means the threat is only going to keep growing.

What’s needed above all is greater transparency and visibility into the sector. The government can begin by building a sound, up-to-date regulatory framework, one that properly defines the roles and responsibilities of non-bank financial institutions. That means forcing shadow banks to provide more detailed information about their products, in particular the types of assets they hold. It also means defining more clearly who’s liable in case of a default.

Not that long ago, China was handing out suspended death sentences for entrepreneurs who solicited deposits outside the banking system. There’s no need for such draconian measures. But China would be wise to bring its shadow banks into the light before risks to the financial system mount much further. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Christopher Balding at cbalding@phbs.pku.edu.cn

To contact the editor responsible for this story:
Nisid Hajari at nhajari@bloomberg.net