Understanding Chinese shadow banking

1. Chinese Shadow Banking:
Understanding KRIs
and risk scenarios

2. 2 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
CONTENTS
Executive Summary........................................................................................................................................4
An Overview of the Chinese Shadow Banking System..........................................................................4
Risk indicators ...............................................................................................................................................6
Should China Halt All Shadow Banking Activities?............................................................................. 7
Scenario Analysis........................................................................................................................................... 7
Possible Solutions.........................................................................................................................................9
The Critical Time: 2015 – 2016 ...................................................................................................................... 10
Conclusion..................................................................................................................................................... 10
References..................................................................................................................................................... 10

3. 3 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
About the authors
This paper is written by industry practitioners of the Hong Kong Chapter of the Institute of Operational Risk and the students
from RMBISA of the Hong Kong University of Science and Technology.
The Institute of Operational Risk (IOR)
The stated mission of the Institute is to promote the development and discipline of Operational Risk and to foster and
maintain investigations and research into the best means and methods of developing and applying the discipline and to
encourage, increase, disseminate and promote knowledge, education and training and the exchange of information and ideas.
Hong Kong Chapter was established since 2011.
http://www.ior-institute.org.
Risk Management and Business Intelligence Students' Association, HKUSTSU (RMBISA)
RMBISA is an association established in 2012 in the Hong Kong University of Science and Technology (HKUST). RMBISA is the
first students' association in the risk management profession in Hong Kong. It provides activities to increase the interest and
awareness of risk management and business intelligence issues among students.
http://ihome.ust.hk/~su_rmbisa/

4. 4 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
Executive Summary
Shadow banking activities have grown rapidly in recent years, especially in China. With a view to gaining a greater
understanding of financial activities in China, this paper provides an overview of the Chinese shadow banking system,
including comparisons between the current situation and past financial crises. Scenario analysis also highlights the inherent
risk within the financial system, while risk indicators and possible solutions are discussed.
An Overview of the Chinese Shadow Banking System
The definition of shadow banking varies from one country to another. The Financial Stability Board defines shadow banking as
“credit intermediation involving entities and activities outside the regular banking system”.
A Comparison between China and the U.S.
The shadow banking system in the US consists of securitized loans and obligations, as well as money market funds. In
contrast, apart from engaging in direct credit extensions made by non-bank entities, China’s shadow banking system involves
informal securitization through a “funding pool” provided by banks and has direct links to commercial banks. Furthermore, the
banks act as important distribution channels for financial products designed by trust companies.
With more than four decades of history, the U.S. shadow banking system is mature – even more so after the 2008 subprime
mortgage crisis that tightened regulations and led to the implementation of greater supervision. In contrast, Chinese
shadow banking has only a 4 to 5 year history, indicating the immaturity of the system, with its inherent high risk and lack of
comprehensive regulations.
The Current Situation in China
A series of restrictive policies have been imposed by the China Banking Regulatory Commission (CBRC) since 2010, including
the raising of the required reserve ratio (RRR), credit rationing and interest rate controls. As a result, different kinds of
off-balance-sheet financing activities in banks have been indirectly encouraged. According to Credit Suisse’s analysis, core
Chinese shadow banking products were estimated at RMB22.8 trillion (approximately US$3.72 trillion) at year-end 2012,
accounting for 44% of China’s GDP in 2012. According to Standard & Poor’s, shadow banking credit in China has been growing
at an annual rate of 34% over recent years.
Exhibit 1 – Estimates of the size of China’s shadow banking system
Source
Est. Value
(RMB tn)
Est. Value
(USD tn)
% of 2012 GDP*
% of On-Balance
Sheet Loans**
Citi Research 28 4.5 54% 41%
Barclays 25.6 4.1 49% 38%
Moody’s 21 – 29 3.43 – 4.73 39% – 55% 31% – 43%
Credit Suisse (Median) 22.8 3.72 44% 33%
UBS 13.7 – 24.4 2.2 – 3.9 26% – 46% 20% – 36%
ANZ Bank 15 – 17 2.4 – 2.7 29% – 33% 22% – 25%
BAML 14.5 2.3 28% 21%
* Official GDP figure of China in 2012 is RMB 52.761 trillion.
** The on-balance sheet loans in China is estimated to be RMB 68.083 trillion in the second quarter of 2013, covering RMB credit funds in people’s banks,
policy banks, commercial banks, urban credit cooperatives, rural credit cooperatives, trust and investment companies, financial companies, leasing
companies, postal savings deposit institutions and foreign funded financial institutions.

5. 5 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
A variety of shadow banking products can be found in
China, ranging from collective trust programs and entrust
loans to bank wealth management products (WMPs)
and local government financing vehicles (LGFVs).
Since 2009, these alternative financing vehicles have
largely been created to fund real estate and infrastructure
construction projects by unsecured developers and local
governments who are unable to raise capital through
bonds. Of great concern is the fact that many of these
projects are over-invested and are unlikely to generate
returns in the short term.
WMPs have been the major source of funding, with issuance
estimated to be RMB 7.6 trillion (approximately US$1.24
trillion) at year-end 2012 – a 55% increase over 2011
(source: CBRC). As WMPs are rolled over at short-term
intervals, more and more new issuances are needed to
pay off the expiring ones. A vicious cycle has developed,
sparking growth in shadow banking activities in China and
rendering these types of investments highly vulnerable to a
sudden shortage of funds.
More importantly, significant concerns have been raised
about the interconnected relationship between banks
and shadow banking activities. A particular fear is that
risk exposure might be heightened owing to a lack of
transparency on these types of investments. The less-
regulated and more complicated shadow banking system
could create system-wide, regional financial instability – or
potentially even a global financial crisis – if the current
situation is not closely monitored.
Wealth
Management
Products
(WMPs)
Local
Government
Financial
Venicles
(LGFV)
Collective
Trust
Programs
Entrust
Loans
Asset-
backed
Bonds
Undiscounted
Bankers’
Acceptances
Shadow
Banking
activities
Exhibit 2 – Shadow Banking Activities in China
Source: CBRC, Nomura Research
WMPs,
Entrusted
loans
Ren Ren Dai,
Private
Lending
Credit
Guarantee
Companies
Financing
Lease
Company
Trust
Companies
Small Loan
Companies
Pawn
Loan
Exhibit 3 – Estimated loan size from different types
of shadow banking as % of total gross loans of Chinese Banks
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%

6. 6 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
Risk indicators
The refinancing risk within the banking industry, as well as the liquidity risk in the Chinese housing market have heightened
the default risk of borrowers and even overall market risk in financial markets. It is essential that investors identify key risk
indicators in order to better understand the drivers that could lead to a deterioration in stability. Five risk indicators have been
identified to help investors to prepare for a potential crisis:
House Prices: The current Chinese housing market is supported mainly by new investments and domestic real estate
speculation, where large sums of money for real estate developments are sourced from WMPs. Weakening housing prices
would lower returns and increase the default risk of loan repayments.
According to current statistics, new house prices are rising at the fastest rate in at least the last 2.5 years and average new
house prices in China’s 70 major cities rose 8.3% year-on-year in August 2013. This percentage growth was similar to that
seen in the U.S. in the peak period before the 2008 subprime mortgage crisis. Even more alarming is that, given Chinese
constructors’ foremost aim of attracting investment, rather than catering to residential demand, the problem of vacant
apartments in China is much more severe than it was in the U.S. The media has claimed that there are approximately 64.6
million empty apartments in China – enough to house 200 million people.
Source: Thomson Reuters
* Calculated by Thomson Reuters based on the price index of newly built residential buildings of 70
large and medium cities published by the National Bureau of Statistics.
-2.0%
Jan
2011
Jul
2011
Jul
2012
Jul
2013
Jan
2012
Jan
2013
Apr
2011
Apr
2012
Apr
2013
Oct
2011
Oct
2012
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
Exhibit 4 – China: Newly Built House Prices Index* (yoy)

7. 7 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
Interest and Inflation Rates: Currently China’s deposit
interest rate is still controlled by the People’s Bank of
China (PBoC). Investing in shadow banking products can
earn a high net interest margin between the controlled
and the black market rates. This high margin attracts
investors seeking high returns, further stimulating the
rapid development of shadow banking in China.
China’s average inflation rate has reached a 3-year low since
2010 and any rebound would lead to a deterioration in the
current situation, as China could increase the deposit rate
to curb inflation. A higher interest rate would reduce the
net interest margin, thereby reducing the amount of funds
flowing into shadow banking products and increasing the
risk of a fund shortage.
Capital Flow
China still has imposed capital account control, i.e. control
on both capital inflow and outflow. As foreign investors are
more skeptical on the prospectus of the Chinese economy,
there are concerns about the decreasing inflow of foreign
capital. Besides, China is moving towards the opening of its
capital account and financial reform which might lead to
the massive outflow of domestic capital to search for higher
yield/return, thus the combined effects could dry up the
local liquidity.
Repo Rate: In late June 2013, there was a spike in the
Chinese bank loan rate, revealing a liquidity problem
within the banks. A high repo rate increases banks’
financing costs on WMPs, thus increasing default risk.
It also puts pressure on mortgage rates, resulting in
reduced speculative investments in real estate, in turn
driving housing prices down.
Required Reserve Ratio (RRR): China’s RRR is about
20%, which is much higher than that in the US (about 10%)
and Europe (1%). A high RRR reduces banks’ ability and
willingness to lend to high risk companies like small-and-
medium sized enterprises (SMEs). These companies are
therefore forced to obtain funding through off-balance-sheet
activities. Although there are no signs of an RRR adjustment,
the scenario of a higher RRR – which would tighten banks’
liquidity and trigger a higher repo rate – is one which
investors should be aware of.
Should China Halt All Shadow
Banking Activities?
Considering that shadow banking activities have already
shaken China’s financial infrastructure, should they be halted
altogether? Yes, on paper, the associated financial risks and
potentially devastating effects are cause for concern, but
the significant scale of shadow banking activities and the
resultant benefits to the economy are factors which support
its continued existence.
The liquidity provided by shadow banking for some high risk
borrowers – like SMEs – should not be ignored. Owing to
the lack of comprehensive credit assessment systems and
the weak credit underwriting system, ordinary banks are
not willing or able to provide emergency loans for SMEs.
Shadow banking can fill these gaps in the banking industry
and accelerate the development of SMEs, which have
become the main catalyst for China’s high economic growth.
Therefore, rather than suddenly and fully terminating
shadow banking activities, China should take steps to
contain a potentially explosive situation.
Scenario Analysis
The final outcome of the shadow banking bubble will
depend on the actions of the Chinese central government.
The effectiveness of its strategies will determine the destiny
of China’s shadow banking activities, as well as the stability
of the Chinese and, by extension, other global economies. On
the whole, three scenarios are predicted.
Scenario 1:
China carries out effective measures to control shadow
banking activities:
This is the most optimistic scenario and likely to prevail if
the inherent risks in the current shadow banking system are
recognized by the Chinese government. Low quality loans,
not guaranteed by central government, would systematically
default and the credit-to-loan ratio would return to a low,
stable growth rate. China’s GDP growth would fall to an
acceptable level, which, compared to the rest of the world,
would still be considerable.

8. 8 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
Scenario 2:
China carries out limited control measures, but these
are not fully effective in controlling shadow banking
activities:
This scenario is likely if effective measures are not carried out
promptly, allowing the shadow banking bubble to enlarge to
an uncontrollable size. The bubble would eventually burst,
causing a simultaneous default of low quality loans and
placing the Tier-3 Chinese banks at risk. China’s GDP growth
could fall by 50% or more, with major implications for the
global economy.
Scenario 3:
China carries out limited measures and these measures
have an immaterial effect on shadow banking activity:
This is clearly the worst scenario and, thankfully, the least
likely to prevail, owing to China’s proactive disposition.
However, this scenario is worth discussing, given the
seriousness of the implications if the scenario were to unfold.
The bursting of the shadow banking bubble would herald
the start of a Chinese financial crisis. China’s near 40-year
real GDP growth miracle could end in recession. Not only
would low quality loans and tier 2 3 Chinese banks be at
risk of default, but even high quality loans would come under
severe pressure. Considering China’s active international
presence, the whole world would suffer if such a financial
crisis were to unfold in China.
Whichever scenario ultimately prevails with respect to
China’s shadow banking system, both domestic and
global economies will be adversely affected by challenging
economic conditions and slowing growth. The different
scenarios merely vary in terms of the seriousness of their
impact. The first scenario would be manageable, while the
third scenario would have a devastating impact.
Domestically, credit conditions would deteriorate, with
restricted lending and less leveraging. GDP growth would
fall owing to weaker consumption and lower investment.
The labor market would come under pressure, leading to
greater unemployment. Depreciating the RMB, increasing
government expenditure and lowering the RRR would
be necessary in order to alleviate the resultant economic
downturn. These measures would lead to higher inflation,
which in turn has social and political implications.
A shadow banking crisis will present challenges to global
economic growth, especially the growth in Asia ex-Japan,
where China has accounted for about one quarter of export
demand. Decreasing demand from China will affect its major
trading partners and direct investors, including the US,
the European Union and East Asia. As the world’s largest
consumer of several key industrial commodities – such
as coal, iron ore and copper – China’s slowdown would
suppress global commodity demand and prices, devastating
commodity markets as well as commodity producers,
including Australia, Latin America and Canada. A weakened
RMB would also worsen the world’s trade balance,
increasing China’s trade deficit.
In terms of global financial markets, the biggest victims
would be foreign companies which have invested in China.
Owing to the restrictions on capital outflow from China,
these companies cannot liquidate their assets and take
back their invested capital easily. Moreover, China’s overseas
investments would decline, while risk premiums would be
heightened in financial markets. However, since the Chinese
stock market only remotely correlates with major global
developed markets, a crash in the Chinese market would
not have immediate consequences for global developed
markets. And undoubtedly, even in the worst scenario, the
negative impact on global financial markets would be less
pronounced than that during the US subprime crisis. Yet, the
financial contagion risk should not be ignored as it would
continue to present analytical challenges.

9. 9 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
Possible Solutions
Five possible solutions are outlined below:
Restrictions on WMPs: As WMPs are rolled-over at short-
term intervals to fund long-term investments, maturity
mismatch is the main underlying risk. By setting a limit on
mismatch ratios or on liquidity requirements for companies
using short-term WMPs, regulators could restrict the use of
short-term WMPs to fund long-term investments.
Moreover, most WMPs only give brief descriptions of their
underlying investments without any further information.
To enhance the transparency of WMPs, the government
should require issuers to clearly state where and how capital
is invested, the inherent risks and the expected returns.
Furthermore government guarantees should be provided.
Reform of Interest Rate Liberalisation: Investors are
earning high margins on shadow banking products. Interest
rate liberalization will allow interest rates to return to the
market level, reducing the net interest margin and thus the
scale of shadow banking. Product returns would then be
constrained by inherent credit risks.
Reforming Banking Regulations: Since the CBRC
imposed restrictions on bank lending activities in 2010, the
growth rate of bank loans has greatly reduced. It is expected
to reduce from 32% in 2009 to around 13.6% over the next
five years. Arguably these regulations have helped banks to
reduce the risk inherent in regular operations, but this risk
has merely shifted into shadow banking activities, which are
harder to control. Regulators should relax the restrictions
for loans so as to shift risk back to the traditional regulated
platform, rendering this risk transparent to both investors
and regulators. More direct measures to regulate off-balance
sheet activities should also be implemented.
Provision of fund-raising platforms for SMEs: Limited
access to fund-raising has forced SMEs in China to borrow
through the shadow banking system. To reduce shadow
banking activity, more funding sources should be provided,
particularly for SMEs. The Chinese government should
accelerate the creation of capital markets and introduce new
investment tools by, for example, relaxing restrictions on
SMEs’ issuance of preferred stocks.
Stress Testing on Banks: Stress tests are commonly
used worldwide to analyze whether a bank has sufficient
capital to withstand the impact of unfavorable economic
scenarios and adverse developments. However, even though
China has applied such tests, they have rarely published
the results in the public domain. Furthermore, stress tests
conducted by local banks are not always standardized
or aligned with international requirements and are only
reviewed occasionally and unsystematically. Standardized
stress tests on banks’ and financial institutions’ systems are
required, with all banks following the same scenarios and
results disclosed to the public. Not only would this help both
the government and banks to be prepared for any potential
problems, but it would also raise general awareness about
banking system health.

10. 10 Chinese Shadow Banking: Understanding KRIs and risk scenarios JANUARY 2014
The Critical Time: 2015 – 2016
China’s RMB capital account liberalization is now being accelerated and is expected to be completed as early as 2015. Upon
completion of the process, it is likely that both large domestic and foreign capital outflows could be triggered. The main cause
of both the Japanese asset price bubble in the 1980s and the Southeast Asian financial bubble in the 1990s was the outflow
of capital. Whether directly or indirectly, a significant proportion of shadow banking activity is financed by foreign capital. In
times of outflow of ‘hot money’, the capital chain is broken, causing a shortage of funds in long term projects. Besides, once
the “hot money” withdraws from China, the demand for both real assets and financial assets would reduce rapidly. As property
developers are the main users of WMPs, a sudden drop in asset prices, together with a shortage of funds, would trigger a large
credit default. A credit contraction would result, severely hindering economic development.
Moreover, given that 2015 is the end of China’s twelfth 5-year plan, most of the projects financed by LGFVs would be
under assessment. The CBRC estimates that total outstanding bank lending to all LGFVs had reached $1.57 trillion
by end-March 2013 and that up to 40% of these loans were at high risk of default. Since most infrastructure projects
generate low returns in the short term, the review would increase the possibility of local governments declaring defaults
and resulting in the bubble bursting.
Conclusion
Shadow banking has brought liquidity to SMEs and acted as the main catalyst for China’s high economic growth. Such
monetary benefits should not be overlooked. However, taking into account the potentially devastating effects of the shadow
banking bubble bursting, the Chinese government should focus on controlling the current situation to minimize the potential
fallout. Given the fact that relevant measures have already been explored and that China holds large reserves, should a crisis
eventually develop, it would not likely be the worst scenario as discussed above. The challenge is how these measures can be
implemented smoothly, effectively and timely.
References
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Economics, November 1.
Chen, Katie (2013), “Loans to Local Government Financing Vehicles (LGFV) Pose Risks to Chinese Banks”, Moody’s Investors
Service, June
Credit Suisse Economics Research (2013), “China: Shadow Banking – Road to Heightened Risks”, February 22
Financial Stability Board (2013), “Strengthening Oversight and Regulation of Shadow Banking”, August 29
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