The concept of shadow banking was first introduced in 2007 by economist Paul McCulley at a financial symposium in Wyoming.
For those unfamiliar with the term, Wikipedia defines the shadow banking sector as the “collection of non-bank financial intermediaries that provide services similar to traditional commercial banks but outside normal financial regulations.”
It consists of financial institutions such as investment companies, credit or hedge funds, pawnbrokers and credit repair companies all operating outside of the watchful eye of the law.
Investors opt for shadow banks in order to achieve higher yields compared to yields offered by regular banks.
China’s shadow banking system has seen huge growth in the last couple of years, due to a couple of different reasons: higher rates of return for investors, capital required for the development of small and medium enterprises, and less onerous lending requirements when compared to the requirements of the traditional banking sector. Small businesses facing a funding crunch, for example, might turn to a shadow banking lender after having exhausted more traditional forms of borrowing.
Almost half of all bank instruments in the shadow banking sector are dominated by two categories: wealth management products and entrusted loans. Wealth management products are investment products that provide a return based on the performance of a pool of underlying assets. Wealth management products are generally offered by banks or trust companies. According to Investopedia, Entrusted loans are loans made by firms in the non-financial economy that are run through banks for legal reasons, but with the banks indemnified from the credit risk of the borrower by the non-financial firm. Other significant instruments are trust loans, bank acceptance bills, informal credit and loans by financial firms.
There are different analyses of the size of shadow banking in China. According to the rating agency, Moody’s, China's shadow banking sector is equivalent to more than 80% of GDP and is worth around $8.5 trillion. The shadow banking system in China has grown by around 30% per year for the last three years. This can be compared to the 10% growth in the rest of the world.
If we talk about the share of each shadow banking instrument, wealth management products stand out the most, with 44% of the total share. The next dominant category is entrusted loans, which make up of 21% of shadow banking. Lastly, trust loans make up 10% of the total.
Despite the significant volume of transactions in the shadow banking system in China, shadow banking is not a serious threat to the stability of the financial system of China, which is small-scale and relatively simply structured in comparison to the risks in some Western countries.
However, we should keep in mind the existence of certain types of risks in the China’s shadow banking sector. The use of derivatives and exposure to sectors that are potential sources of financial crisis does not pose the greatest risk, but there is a significant risk that investors will stop buying wealth management products and opt to park more of their money overseas. In that case, banks will have no alternative option but to stop giving loans to new entrepreneurs.
Another risk for China’s banking system is the discrepancy between the maturity of short-term investments and long-term loans. Yields on wealth management products are based on assets, but the duration of the product is significantly shorter. The average maturity period is up to three months, although loans can be applied to mortgage loans or other long-term loans.
Although the settlement obligation in China is at a low level, it should be noted that the risk profile of the largest debtors (SMEs and entrepreneurs) is generally higher than the accepted banking average for clients. The risk increases in the real estate sector, which was approved the third of all bank loans in the shadow banking sectors. Despite the fact that there is no guarantee for loans, Chinese investors almost unanimously expect the country will cover all the possible losses.
After three years of consecutive growth of 30% or more every year, Chinese shadow banking faced significantly less dynamic growth in 2015.
The slow pace of growth in the shadow banking sector can be explained by the following reasons:
- The decisions of the official banking sector of China to attract products and customers who were previously directed to the shadow banking sector.
- State efforts to control the riskiest aspects of the shadow banking sector.
- The possibility of easier regulatory measures which were limiting activity of the banks.
- Insufficient loan demand.
There are two different scenarios that could indicate future trends of China’s shadow banking system. The key participants in these scenarios are banks themselves.
The first scenario assumes that banks would withdraw from the shadow system and that banks will determine if it is profitable for them to credit existing debtors based on the analysis.
The second scenario assumes that the official banking institutions will overtake shadow banks. There is no doubt that the shadow banking will change its form in the future, so that it will either disappear or evolve into a more sophisticated solution that has already been patented in some Western countries (i.e. through securitization). Indeed, when I spoke with Name of WHAT CAPITAL, he told me: “The only thing we can be certain of in China’s shadow banking sector is continued change, particularly in light of Beijing’s efforts these past few years to tackle what it views as a growing problem.”
The global financial crisis pointed out the fact that problems outside the regular banking sector, known as shadow banking, can have big consequences on the world’s economy. Since activities of shadow banking are recognized in a very similar manner as is the case with traditional banks, these institutions remain outside the framework of the official regulatory system and consequently undermine the stability of the existing system.
Michael Michelini is host of the GlobalFromAsia.com podcast, an online radio show to help business owners grow their companies in Asia and around the world.