The Shadow Banking Problem in China

Guest Author: Waiching Li

Despite Chinese government’s efforts to rein in liquidity by hiking rates and raising the reserve limit to an unprecedented 21%, the consumer inflation index has risen 5.5% over the past year. That level is a three years high, according to figures released by Chinese government on Tuesday.

In China, the persistence of inflation pressure has brought “shadow banking” into a topic of hot debate recently. According to a study issued by the People’s Bank of China in 2010, non-banking sector lending has expanded to 63.3 trillion Yuan, ($10 trillion), 44.4% of total lending activities of China’s economy.

Shadow banking, a concept coined by the US Federal Reserve, refers to non-banking financial institutions with some banking functions, but they are not or less regulated like a bank. In the U.S., the lack of regulation for the securitization of traditional financial products, including home loans, was one of the major causes of the financial crisis.

Shadow banking in China mainly exists in the form of "Bank and Trust Cooperation", the underground financing networks; but small loan companies and pawn shops also play a role in these shadow financing activities.

While mortgage securitization is not an issue in China, the “Bank and Trust Cooperation” is a vehicle to provide ‘hidden’ loans to enterprises outside the scope of the bank’s reserve limit. Similar to the credit securitization problems in the US, the banks play the role as an intermediary. They charge service fees and commissions for services provided, while referring the securitized loans to banks customers, and raising funds off the bank’s balance sheet.

Data released on March 31th, by China Trustee Association, shows that the scale of Bank and Trust Cooperation as has already reached to 15.3 trillion yuan ($2.35 trillion). The risks of such financial arrangements are asymmetrically transferred to buyers. Since no credit ratings are available for these debts, the buyers have to blindly follow the bank’s referrals, hoping the banks, which make money from commissions and fees no matter what happens with the loan, have done due diligence and are honest.

Fortunately, unlike the mortgage backed securities that traumatized the US economy, the assets of China’s “Bank and Trust Cooperations” are yet to enter the stage of complex financial leverage. Also last January, the CBRC ordered commercial banks to incorporate this type of lending into their balance sheets by the end of this year.

It’s a step up to curtail risk, but industry insiders doubt the incorporation process will be completed by the end of this year. They also worry that the increased tightening on banks will further increase illegal underground banking. Unlike the ‘Bank and Trust Cooperation’, which sits in a legal haze; underground banking, illegal per se, is almost completely unmonitored.

It’s estimated by Chinese media that the size of underground banking is in the trillions of dollars. The true number is difficult to determine. Every once in a while, the news reports about a police raid on an illegal financing network gives a glimpse into the ever-enlarging scale of underground banking.

Underground banking gets to thrive on the deficiencies of China’s monetary policy. On one hand, the bank’s interest rate can’t keep up with inflation on the street; on the other hand, cash strapped private businesses can’t get loans from commercial banks because state enterprises have a higher priority. Since, in many places, underground banking generally promise at least 5 times higher returns than legal banks, market forces allow the underground banking to flourish.

Shadow banking in China will continue to grow as long as commercial bank lending is unable to meet liquidity demand and interest expectation. However the scale of shadowing banking is undermining the effectiveness of monetary tools to combat inflation. Since last October, China’s central bank has raised reserve requirement ratio nine times already, but the inflation pressure still remain high.

Early in May, the Chairman of the China Banking Regulatory Commission, Mr. Liu Ming Kang spoke out at the 22nd committee meeting, claiming that one of the major risks the banking system faces is ‘shadow banking’. This is the first time that the CBRC has raised the red flag. Such a statement indicates the increasing uneasiness the regulatory body is having, while trying to engineer a soft-landing.

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About the Author

Waiching LiWaiching Li is an independent trader living in Boston. She received a MBA concentrated in Finance from American University and has a BA in accounting from the University of Wisconsin-Madison. She has previous work experience in financial services. Her trading is currently concentrated in the Hong Kong stock market. She frequently visits Hong Kong.

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