China shadow banking: the good, bad and ugly

China’s shadow banking market - which has been described as one of the great dangers to global financial stability - was a hot topic for asset owners and economists at the recent Boao Forum for Asia, China’s annual meeting of politicians and business leaders.

Xie Ping, deputy general manager at China Investment Corporation, said China’s shadow banking market operated in a different manner from those of other countries, particularly in relation to  participating institutions and the extent of regulatory arbitrage activities.

“Chinese financial institutions, commercial banks, trust companies and securities firms are all involved in shadow banking in China. They are not the major participants in overseas markets,” said Xie.

He noted that the four main regulatory arbitrage activities include avoiding requirements on extra reserve ratios, capital adequacy, interest rate policy and total loan amounts.

Commercial banks can side-step the regulations by utilising shadow banking products, which also offer a higher profit margin than regulated bank products.

A typical example are the trust schemes which commercial banks use for corporate customers. Such loans are often wrapped into trust investment schemes or special purpose vehicles, which the banks hold off balance sheet.

“The funds ultimately go into real estate investments or corporate bond and local government-backed investment units,” Xie said.

“Most investors enjoy an annual yield between 5% and 5.5%, but for borrowers the average funding cost is 10%,” said Xie. “The rate differential has created a profit chain (management fees) for participants, including commercial banks and trust companies.”

Since most of these wealth management products or trust schemes are distributed by commercial banks, investors assume these investments provide “implicit guarantee” from the banks, Xie said.

Such arrangements have created moral hazards in the China’s financial system, he said.

The Boao delegates discussed whether the regulatory arbitrage activities are the real evil, or if shadow banking is totally a bad thing. Chen Zhiwu, professor of finance at Yale School of Management answered ‘No’. The term ‘shadow banking’ sounds bad, he said, but it has boosted China’s private sector growth in recent years.

China’s lending and saving rates are constrained by government control, with most commercial bank loans going to state-owned enterprises. In contrast, shadow banking provides financing to private-owned enterprises at a higher borrowing cost, Chen said.

Highly regulated financial activities do not guarantee safety. The risk elements of the 2008 financial crisis came from highly-regulated commercial banks and investment banks in the US, proving that tight regulation was not always able to reduce market risk.

Chen argues the growth of trust schemes and wealth management products in shadow banking represents a non-banking capital market which regulators should not attempt to curb.

Despite its function as an alternative financing channel in China, shadow banking activity has also brought competition to commercial banks and fund management companies, Chen said.

“Mutual fund firms have struggled in asset growth in the past five years, commercial banks are also finding it difficult in the savings market due to the competition from wealth management products,” said Chen.

Chen also argues that China’s shadow banking has positive influence on product innovation and helps maintain pressure for interest rate liberalisation.

Estimating China’s shadow banking is a difficult task due to varying definitions. Xie estimates China’s shadow banking stands at Rmb15 trillion, while Credit Suisse research estimates Rmb56.7 trillion and the Financial Stability Board estimates only $4.39 trillion.

However, these estimates all confirm that China’s trust schemes have been the major component in shadow banking.

“The biggest risk in China’s shadow banking is default risk of the trust schemes and corporate bonds. Few cases have occurred and at this stage the possibility is still low,” said Xie.

He stressed that China’s shadow banking is not as dangerous as people think, because it does not involve heavy use of derivative instruments. Most of the funds are used for direct loan financing, investments in IPOs, bonds, private equity funds and new share placement.

As an institutional investor in China, Mark Machin, president of Canada Pension Plan Investment Board (CPPIB) in Asia, worries that shadow banking might affect financial stability.

Loans in China’s shadow banking are exposed to excess-capacity industries like property and mining, but the underlying investment product pricing is not taking account of credit risk, he said.

Since most shadow banking activities are off balance sheet, bank investors will find it difficult to see the hidden risks.

Alexander Begbie, chief operating officer at Standard Life, suggested the Chinese government should regulate such shadow banking activities, otherwise it could become a kind of “Ponzi scheme”.

“We have a joint venture company in Tianjin and we are worried about the development of wealth management products which feature an implicit guarantee,” said Begbie. “I think such products are not sustainable, and the government should impose more regulation.”