Is the System of Shadow Banking in China a risk for the Chinese Financial System?

Is the system of
shadow banking in
China a risk for the
Chinese financial
system?
ORIOL CAUDEVILLA
VISITING SCHOLAR – CENTRE FOR CHINESE LAW (HKU)
ORIOLCAUDEVILLA@ICAB.CAT

Index
1. CONCEPT OF SHADOW BANKING.
2. INTRODUCTION TO THE CHINESE FINANCIAL
SYSTEM.
3. SHADOW BANKING IN CHINA.
4. DOES SHADOW BANKING IMPLY A RISK FOR THE
WHOLE CHINESE FINANCIAL SYSTEM?
5. ALTERNATIVES AND SOLUTIONS.
6. CONCLUSIONS .

Shadow banking refers to
those activities performed by
the financial intermediaries
involved in facilitating the
creation of credit across the
financial system, but whose
members are not subject to
regulatory oversight.
Shadow banking may also
refer to those unregulated
activities performed by
regulated institutions.
In other words,
credit
intermediation
outside the
conventional
banking system.
In other words,
credit
intermediation
outside the
conventional
banking system.

Source: IMF Report on Global Shadow Banking (October 2014)

These activities lack a strong safety net and usually have a lesser level of regulatory
oversight
risks for financial stability
Shadow banks include among others:
•informal securitized loans and other credit-based assets through wealth management
products (WMPs);
•Money market funds;
•Investment funds;
•SPVs;
•Trusts and trust-bank cooperation: entrusted loans;
•Bankers’ acceptances;
• Numerous others: leasing companies, finance companies, loan guarantee companies;
micro finance lenders; underground banks; person to person lending; and pawn shops.

Main risks of the shadow banking system:
As shadow banks do
not take deposits,
they are subject to
less regulation than
traditional banks.
Shadow banks can
increase rewards
from investments by
leveraging much
more.
Shadow banks can also
cause a build-up of
systemic risk indirectly
because they are
interrelated with the
traditional banking
system.
As shadow banks use a
lot of short-term
deposit-like funding but
do not have deposit
insurance, a loss of
confidence may lead to
“runs” on these
unregulated institutions.
Shadow banks
collateralized funding is
normally considered as a
risk, since it can lead to
high levels of financial
leverage.

Shadow Banking all over the world
Between 2007 and 2015, shadow
banks have increased their share
of the U.S. Federal Housing
Administration mortgage
market sevenfold to 75 percent.
According to the Financial Stability
Board, "other financial
intermediaries" -- the category that
includes non-bank lenders but not
insurance companies and pension
funds -- increased their assets to $80
trillion, or 23 percent of total financial
assets, in 2014. Their average growth
reached 5.6 percent in 2011 through
2014, while the global banking
system's assets stopped growing
during that time.
FSB estimates a recent pickup in
shadow banking activity in the
euro area, the United Kingdom,
and the United States.

Shadow Banking all over the world:
•

2. INTRODUCTIONTOTHE
CHINESE FINANCIAL
SYSTEM

China’s financial system has
managed for several decades to
perform well enough to support
the very rapid economic growth of
that nation.
The financial system plays a
critical role in fueling the
expansion of China, which has
grown to be the second largest
economy in the world and is likely
to eventually surpass the US.
Many analysts believe that the
financial system represents a
major vulnerability for China’s
economic development, whereas
others, equally respected, think
that the financial system is
adapting effectively to China’s
more developed status and will
continue to provide the necessary
fuel for the rest of the economy.

China’s financial system is particularly hard to analyze because it is highly opaque
and evolves rapidly.
Only a few decades ago the private financial sector virtually did not exist and all
banking was done through branches of the state-owned People’s Bank of China.
A factor encouraging opacity is that China’s national, regional, and local
governments play a much bigger role in directing the activities of banks and other
financial intermediaries than in America or Europe.
To some extent, the banks make loans as a substitute for fiscal actions that would
otherwise need to be taken, as was clearly shown in the use of the banking
system to provide the bulk of the economic stimulus after the global financial
crisis struck in 2008

In addition, there is a wide variety of implicit guarantees embedded in the
financial system.
These represent assumed support by the central government for the borrowings
of state-owned enterprises, support for state-owned banks, implicit deposit
guarantees (since there is currently no formal protection of deposits), the
assumption by many investors that banks or trusts will cover losses on wealth
management products, etc. Implicit support is more opaque, easier to
misunderstand, and riskier, than more formal arrangements.
The leading role of the Chinese Communist Party is enshrined in the Constitution
and is very much evident across all sectors of the economy, especially banking.

a) Banks
dominate the Chinese
financial system,
providing the private
sector with credit
mounting to about
128% of Gross
Domestic Product
(GDP) in 2012,5
compared to 48% for
the US.
b) The bond market: under-
developed, providing credit
equivalent to approximately
41% of China’s GDP,
compared to 243% in the US
We will see a contrast with
Western economies, where
the stock market is typically
smaller than the bond
market.

c) Stock markets: often compared to casinos,
driven heavily by speculation rather than end-
investment. Aggregate market capitalization
of about 44% of domestic GDP in 2012.
Average annual turnover rate in the Chinese
stock markets over the past 5 years was 205%,
reaching a recent high of 293%, compared
to the US rate of 188%.
When only negotiable shares are taken into
account, the average turnover rate over the
past five years increases to 341%, and in
recent years the annual rate has been as high
as 666%.
The market for initial public offerings (IPOs) is
particularly prone to speculative excess

d) Insurance companies:
another under-developed part
of the Chinese financial system,
holding $1.2 trillion in assets, or
just over 14% of GDP. The scale
of the insurance industry is thus
relatively small .
For example, US insurers have
over $4.8 trillion in total assets,
amounting to over 30% of GDP.
e) Asset Management
Industry: even less
developed compared to the
West, particularly compared
to the prominent role played
by mutual funds in America.
Assets under management in
China are equivalent to only
about 5.1% of GDP,
compared to 240% in the US.

Source: Elliott and Yan (2013).

Structure of the Banking Sector

Structure of the Banking Sector:
Source: Lan Sun (2014)

Structure of the Banking Sector and
Shadow Banking
PROBLEM:
Several
reasons
have been
proposed
by leading
academic
and
business
journals to
explain the
existence
of a sizable
informal
financial
sector.

There are a
number of
pressures
pushing
business away
from banks
towards
shadow banks,
including theincluding the
fact that…fact that…
(Elliott, Qiao:
2015):
Local private firms have very limited access to bank loans, the bond market and the stock
market. Therefore, they are almost forced to acquire funds from informal channels. Thus,
the need for a SHADOW BANKING SYSTEM in China.

Reasons why there is the need for a shadow banking system in China, just explained.
Source: Elliott and Yan (2013).

Since late last year, the PBOC and
regulators have taken steps to rein in
risks to China’s financial system,
including raising short-term interest
rates, clamping down on leverage in
the bond market, and curbing
funding for property speculation.
The measures have sent debt-reliant
borrowers scurrying to shadow
financing, an industry Moody’s
Investors Service estimates is worth
about $8.5 trillion.
Wealth management products
Often sold by banks and other
Chinese financial institutions to
ordinary Chinese investors with the
promise of interest rates much
higher than what banks offer for
deposits, but the obligations are
often kept off bank balance sheets.

The size of China’s aggregate
financing, was up 3.4 per cent
from a year earlier to 6.93 trillion
yuan (US$1 trillion) in the first
three months of this year.
Broken down, off-balance sheet bank
credit saw rapid growth in the first
quarter. Trust loans grew by nearly four
times to 734.9 billion yuan, entrusted
loans – organised by agents between
borrowers and lenders – advanced by
15.7 per cent to 634.7 billion yuan, while
bankers acceptances (short-term credit
investments created by a non-financial
firm and guaranteed by a bank to make
payment) surged by 900.5 billion yuan
compared with last year.
As such activities often contain
high risks, Chinese central bank
governor Zhou Xiaochuan
introduced a so-called macro
prudential assessment (MPA)
system, comprised of dozens of
indicators, to encourage banks to
put all credit activities on their
books, instead of hiding them.

The PBOC in January ordered the nation’s lenders to strictly control new loans in the first
quarter of the year, putting a particular emphasis on mortgage lending to contain
runaway home prices.

Net corporate-bond financing in China was negative for three consecutive months
through February before logging a positive 32 billion yuan in April. The negative streak,
during which more bonds matured than were issued came amid tighter rules on issuance.
If companies can’t raise funds from the bond market, they have to turn to shadow
financing.

The contribution of shadow banking to the nation’s economy has risen in recent months:
Off-balance sheet funding accounted for 15.7 percent of the country’s total corporate
financing by the end of March, up from 15 percent at the end of last year, PBOC data
show.

Technically, these financial intermediaries are often in violation of Chinese law. But local
governments, knowing the existence of these financial intermediaries, usually allow them to
continue operating unless there is evidence that they may have done harm to the local economy
One way of evaluating the current situation of the Chinese informal financial sector is by taking a
look at Wenzhou.Wenzhou.
Wenzhou is famous for its industrial output and at the beginning of the reform era generated a
group of high net worth individuals. The GDP of Wenzhou reached RMB 243 billion in 2010, with
per capita GDP being RMB 40 thousand, compared to a national average of RMB 30 thousand.
About 300,000 small private firms produce more than 90% of the local output, with about 70% of
them relying heavily on exports.
Since the Chinese economy has slowed down and the global financial crisis, combined with the
ensuing Euro Crisis, has reduced foreign demand, many local firms have experienced a drying up
of liquidity.

The local informal financial sector provided short-term liquidity for the local firms during this
period. The liquidity provision was mainly done through very short-term but high-yield loans. For
example a loan could be as short as 3 to 5 days, and the annualized yield could reach 70%. It is
estimated that the magnitude of the informal financial sector in Wenzhou reached RMB 700
billion
In 2011, the local court sentenced one of the CEOs f the underground financial system to death,
convicting her of “illegally gathering investors’ money”.
This case was brought to national attention by some very prestigious economists, who insisted
that “illegally gathering investors’ money” should either not be a violation of the law or should
not receive such a severe sanction. Prime Minister Wen Jiabao himself also asked the court to
“reconsider carefully the accusation and the final verdict”. In the end the Supreme Court repealed
the death sentence.
This case is widely seen as providing an impetus for further financial reform in Wenzhou

The need for Shadow Banking in China

4. DOES SHADOW BANKING
IMPLY A RISK FORTHE
WHOLE CHINESE FINANCIAL
SYSTEM?

The growth of unregulated, opaque shadow banking activities poses a systemic
risk to China’s financial system
Yi Huiman, chairman of the Industrial and Commercial Bank of China, which is the
world’s largest bank as measured by assets, warned about the rapid spread of
unregulated investment vehicles, such as wealth management products.
While deleveraging and reducing financial speculation are positive for the long-
term development of financial markets, high lending rates and slowing credit
growth could weigh on economic growth.

Research note HSBC:
“If banks are forced to scale back
off-balance sheet wealth
management products or to slow
credit growth, that could lead to
rising near-term defaults and
asset quality risks as some
borrowers of shadow banking
loans may not be able to rollover
their loans”

Bank WMPs: Majority are
loan-based (40-50% vs.
Regulatory decree of 35%)
and the number of loans is
limited; so credit risk
diversification is weak; no
rating system, no tranching
based on credit risk, no
secondary market; so
liquidity risk is excessive;
Maturity of
WMPs is
shortening.
In 2007, less than 10% were
less than 90 days, and more
than 50% were a year and
above; by end 2010, about
40% were less than 90 days
and 20% were a year or
over; in 2017, 60% less than
90 days.Banks often act
alone in originating,
distributing,
custodying and
managing WMPs;
fund pooling;
contagion risks are
high – Xiao Gang
“Ponzi scheme”;

Systemic Risk “5-30 rule”? Ratio
of debt to gross domestic product
surpassed 250% in 2016.
Situation resembles 66
percentage points credit growth
in Thailand and 40 pp growth in
Malaysia five years prior to the
Asian crisis: 60 pp of increase in
China in 2016(the financial crisis
in large economies are usually
preceded by a sharp rise in the
leverage ratio, by 30% of GDP in
five years and is known as the “5-
30 rule”).
Increasing indebtedness,
coupled with potential
slower growth and worsened
corporate profitability, may
make businesses more
susceptible to financial
distress and failure, and it
also increases the level of
non-performing loans (NPLs)
for the banking sector.

Given the
interconnectedness between
shadow banks and the
formal banking sector, risks
in the shadow banks can
easily be transmitted to the
major commercial banks. Shadow banks bring
important financial stability
risks, because of less
stringent regulation, lower
safety margins, riskier
business models, and
opaque business methods.

SHADOW BANKING
IMPLIES A RISK FOR THE
CHINESE FINANCIAL
SYSTEM, BUT A RISK
MUCH LOWER THAN IN
MANY OTHER
COUNTRIES, SINCE THE
CHINESE FINANCIAL
SYSTEM IS QUITE
UNIQUE AND PECULIAR.

Will there be a major shadow banking crisis in China? (Elliott, Kroeber and
Qiao, 2015)
China’s shadow banking sector, however defined, is substantially smaller
(relative to GDP) than those of financially advanced countries in North
America and Europe, and towards the middle of the range for major
developing countries.
The near-term risk to the financial sector and the wider economy from a
shadow banking crisis in China is lowlow. There is certainly a real risk of a
crisis within the shadow banking sector. However, if such a crisis did
occur, say via the serial bankruptcy of several trust lenders, it is likely
that the impact of the crisis could be contained and would not lead to
serious contagion in the rest of the financial system.

According to the same authors,
• In its present form, therefore, China’s shadow banking sector presents relatively
low risk of triggering a panic or financial crisis similar to those experienced by the
U.S. in 2008, or by other Asian economies and Russia in 1998. The fundamental
reason for this is that liquidity is abundant, due to the high levels of deposits from
households and businesses, and reliance on fragile wholesale funding sources is
minimal. Bad events such as a property market crash, a dramatic heavy-industry
slowdown, or defaults in the trust companies would certainly increase banks’
non-performing assets, but they would not imperil banks’ funding.
• The bigger financial system risk in China is not crisis but sclerosis: if an ever
greater share of lending (whether by banks or shadow entities) goes to
unproductive projects, then economic growth will continue to decelerate. This is
in essence what occurred in Japan in the 1990s

Is there a real need for shadow banking activities in
China?
The very large traditional banking
sector is not fully serving the
increasingly complex financial needs
of an economy transitioning from a
focus on industry and infrastructure
to one based mainly on consumer
services and also moving from state
ownership and control to a greater
level of private enterprise.

How can the Chinese authorities curb shadow banking but, at the same
time, meet the needs of all these companies that require financial
services to be more widely available in China?

Since the emergence of wealth management products and trust loans on a
large scale in 2010, the principal financial regulators, the PBOC and the CBRC,
have taken a cautiously welcoming view of the shadow sector (Elliott, Kroeber
and Qiao:2015).
At the same time, however, regulators had two broad concerns: first, that an
unregulated shadow finance sector could create excessive credit growth; and
second, that the lack of transparency in the sources and uses of funds could
create hidden risks, much as occurred in the U.S. before 2008

Regulatory efforts since 2013 have focused on:

Efforts to make shadow activities more transparent are
embodied in a series of regulatory documents:
The State
Council’s
“Notice on
Some Issues of
Strengthening
the Regulation
of Shadow
Banks”
(Document No.
107, January
2013) .
The CBRC’s
“Notice on
Regulating
Commercial
Banking
Interbank
Business”
(document no.
140, May 2014).
The multi-
agency “Notice
on Regulating
Financial
Institutions’
Interbank
Business”
(State Council
document no.
127, May 2014).
Document 107 essentially banned
the practice of “fund pools,”
under which trust companies and
other WMP issuers could move
money indiscriminately from one
investment to another. This had
made it impossible for buyers of a
given WMP to know what exactly
they were investing in. The other
two notices proposed new rules
for financial institutions’
management of interbank
liquidity.

Not many alternatives. Since the traditional banking system in China does not meet the
needs of many companies, these companies need some alternative source of financing.
We do not think that shadow banking should be banned, but some solutions could be
adopted:

China’s shadow banking sector is not especially large by international standards.
It is relatively simple, and is overseen by regulators who have so far shown themselves
alive to the most important risks (namely funding risk and lack of transparency) and have
taken prudent steps to minimize these risks.
Shadow banking brings important financial stability risks, because of less stringent
regulation, lower safety margins, riskier business models, and opaque business methods.

The authorities take seriously their mandate to maintain financial stability.
Problem: traditional banking system does not fully serve the needs of many companies
Shadow banking provides important services in China, as it assists in the ongoing move
away from state control and towards a more market-based economy.

China needs shadow banks to supply needed credit to sectors that traditional banks do
not serve well, but financial stability and investors need to be protected at the same time.
Non-bank financial institutions should be encouraged, but they should also be regulated
more carefully and comprehensively.
A formal banking sector that served society better would eliminate much of the pressure
for regulatory arbitrage that produces shadow banking and would push non-bank
financial institutions to focus on areas where they have true economic advantages and not
just regulatory benefits.

Is the system of
shadow banking in
China a risk for the
Chinese financial
system?
ORIOL CAUDEVILLA
VISITING SCHOLAR – CENTRE FOR CHINESE LAW (HKU)
LEGAL ASSISTANT/BUSINESS ANALYST AT YUXING INFOTECH INVESTMENT HOLDINGS(STOCK CODE: 8005).
ORIOLCAUDEVILLA@ICAB.CAT

Is the System of Shadow Banking in China a risk for the Chinese Financial System?

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