C P Chandrasekhar & Jayati Ghosh

Who’s afraid of China’s shadow banking?

CP CHANDRASEKHAR JAYATI GHOSH | Updated on January 23, 2018

Grey area The influence of shadow banking LANTERIA/SHUTTERSTOCK.COM

chart 1

chart 2

It still remains small in relation to total bank credit in China. However, to the extent that shadow loans have been made in real estate and construction, there is a threat

Shadow banking has had a bad name globally, ever since it was identified as an important source of the perverse incentives, irresponsible behaviour and excessive credit creation that culminated in the global financial crisis of 2007-08 and the consequent Great Recession.

It is widely felt that allowing the proliferation of such financial activities is both problematic and risky — and therefore the extraordinary increase in such activities in China in the past few years has become an object of scrutiny. In fact the scrutiny has also spilled over into concern. Some have gone as far as to argue — as an article in Time magazine did last year — that Chinese shadow banking represents a threat not just to the Chinese economy, but even to global financial stability.

The growing shadow

What exactly is shadow banking? Very broadly, it refers to credit creation that is not subject to regulatory oversight, falling into the crevices or “shadows” that regulation does not cover.

It can be engaged in by institutions that are financial intermediaries but not treated in the same way as banks, or even by banks that indulge in some unregulated activities. Estimates of the extent of shadow banking in China vary wildly, from a low estimate of 8-22 per cent of GDP in 2013 (by Standard Chartered Bank) to a high of as much as 70 per cent of GDP in the same year (by JP Morgan).

However, most estimates, including those of the IMF, the Chinese Academy of Social Sciences and various other sources, suggest a value of the sector in the range of around 35-40 per cent of GDP.

This is certainly high, but not anywhere near as high as shadow banking in some developed countries.

For example, shadow banking is still estimated to account for around 150 per cent of GDP in the US and 348 per cent in the UK and as much as 760 per cent in the Netherlands (according to the Financial Stability Board of the BIS).

So by international standards the size of the shadow banking sector may not seem to be that much, or such a cause of concern. However, two other factors need to be borne in mind.

First, that the various estimates may still be underestimates because of the significant involvement of banks in shadow banking activity (as will be elaborated below).

And second, because of the extremely rapid growth of this sector in the recent past, suggesting uncontrolled expansion with all sorts of possible repercussions.

As Chart 1 indicates, the really significant expansion of shadow banking occurred in the aftermath of the global financial crisis, allowed and to some extent even encouraged by the Chinese financial authorities in an effort to expand domestic demand along with the stimulus provided by public investment.

In recent years, the expansion has been particularly rapid, as not just non-bank financial institutions but the commercial banks themselves have got more involved in shadow lending activities.

Shadow banking in China can be divided into several categories. There are loans made by trust companies that are not banks. Then there are “entrusted loans” made by non-financial firms that are run through banks for legal reasons, where the credit risk of the borrower is held not by the bank but by the investing firm.

Then there are bankers’ acceptances, or certificates issued by banks promising unconditional future payment. There are inter-bank “entrusted loan” payments.

And finally there are also loans made by other entities such as microfinance institutions, leasing companies, guarantee companies, pawn shops and unofficial lenders.

Various wealth management products as well as some new forms of derivatives are also part of this last category.

What is possibly specific to China is the extent to which the formal banking system is involved in these, largely as a way of circumventing the various rules and regulations that would otherwise prevent certain types of bank lending.

Banks are integrated into the shadow banking system through both on-balance-sheet and off-balance-sheet loans as well as through reliance on “alternative” funding sources beyond deposits.

Beyond regulation

Thus, many shadow banking activities are specifically designed to circumvent regulation on the banks, and are therefore a form of internal regulatory arbitrage.

For example, there are caps on lending volumes of banks, and bank regulators tend to discourage loans to particular sectors that are seen as developing bubble-like characteristics or becoming excessively risky.

In the past few years, such sectors have included local government financing vehicles, real estate developers, coal miners and ship builders. Despite banking controls, loans to such sectors actually continued to increase, because they were routed through shadow lending.

In addition, because they fall out of regulatory cracks, such shadow loans are not subject to reserve and capital requirements and also have more flexibility with respect to interest rates, allowing higher deposit and lending rates.

This last has also been a major attraction of the wealth management products for China’s new rich, who are increasingly willing to take on higher risks in exchange for potentially higher returns.

All this suggests a classic recipe for financial trouble ahead, as it is so reminiscent of what occurred in the US and some parts of Europe before their financial crises.

However, this may not be the correct conclusion to draw in the current Chinese case.

Shadow banking still remains small in relation to total bank credit in China, which is estimated to be a whopping 270 per cent of GDP.

Most importantly, shadow loans are probably fully covered by the deposits of banks, so a crisis is unlikely to result from those on their own.

However, to the extent that shadow loans have been made in sectors in which the bubbles are subsiding or growth is slowing down, the shadow banking sector reflects in more extreme form the general problem plaguing Chinese banking: the maturity mismatch whereby short-term deposits have been taken to make more long term loans.

Chart 2 indicates how medium and long term loans have grown in proportion to account for more than half of outstanding credit.

Much of this has been directed towards housing and real estate, which are experiencing slowdown, as well as some mining and infrastructure sectors that currently also face problems.

There were obviously good reasons why regulators in China wanted banks to reduce lending to such sectors.

If they failed (because banks and other institutions adopted alternative routes to such financing through the expansion of shadow banking) then the consequences for both banking and economic activity are unlikely to be pleasant.

Published on May 25, 2015

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