The Financial Stability Board (FSB) in its 2013 annual report on Shadow Banking titled, ”Strengthening Oversight and Regulation of Shadow Banking”, defined shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system” or “non-bank credit intermediation in short”.

Shadow banking means banking equivalent activities conducted by firms, who are not banks as defined by the banking act of the respective sovereign; nor do they fall within the regulatory jurisprudence of its respective central bank or regulatory authority by whatever name called. These firms are characterised by the absence or lesser level of “regulatory oversight” and “safety net” like government funded deposit guarantee and lender of last resort facilities. However, the risks faced by these shadow banks are similar to banks, namely, counterparty default risk, maturity mismatch and liquidity freeze.

In China, shadow banking products which are commonly used are loans and leases by trust companies, entrusted loans, loans from micro finance companies, trust beneficiary rights, wealth and asset management products, special purpose finance companies associated with e-commerce, inter-bank market (even corporations participate in this market), pawn shops, guarantees, unofficial lenders, financial leasing to name a few.

What led to the rise of the shadow banking in China?

The financial backdrop against which the phenomenal rise of shadow banking played out was that of a ceiling on deposit rates, lower return on sovereign treasury bills and papers, lack of alternative savings and investment instruments for investors, need for a profitable avenue for banks to deploy, credit tightening towards risky sectors like real estate and post crisis stimulus. The stimulus package after the crisis of 2008 ($586 billion) was funded 30% by the central government. The rest was mandated to be funded by local government borrowing. As local governments are restricted from taking on debt on its own books, local government financial vehicles (LGFV) were deployed to borrow from banks and shadow banks to provide funds for the stimulus package. This measure provided a significant impetus to the growth of the shadow banking in China from 2008 onward.

Type of shadow banking products

Shadow credit in China originates from three sources:

1. Wealth and Asset management products. This includes Wealth Management Producgts (WMPs) and Asset Management Products (AMPs), worth $15 trillion. Funds raised by banks through these products are deployed in the interbank market, bond and stock market.

When Chinese banks internally off-load assets / loans into off-balance sheet products, they are referred to as “Wealth Management Products”. These products are then sold to depositors or investors as savings product. Thus, banks can significantly escape quality assessments of the loan book that has been re-packaged and also deposit regulation.

Banks sells its loans to external non bank entities, who then package these loans into Asset Management Plans and the originating bank “invests” in these AMPs (i.e. these AMPs are resold to the originating bank). So what was initially a loan (in all probability a stressed loan) is now converted into an investment.

2. Non bank financial institutions like trusts, broker dealers and insurance companies. These entities can solicit funds from investors (individual and corporate savers) through banks who act as middlemen. Trust loans are mostly extended to riskier segments like real estate development, local government infrastructure projects, mining and small companies. Trust companies employ a complex array of financial structure to route liquidity to beneficiaries which makes untangling the transactions extremely difficult and places it beyond the scope of regulators to investigate.

Entrusted loans are loans organised by an agent bank. The agent bank is called the trustee and the provider of funds is called the trustor. Entrusted loans are generally used by commercial enterprises which may have some idle funds to lend out and earn interest. They appoint an agent bank who gets a borrower for the funds. Banks, acting as agents or trustees do not disclose this credit risk and is kept off balance sheet.

3. Informal lenders (non banks) who extend loans to those who do not have access to the formal banking system like pawn shops and unofficial lenders.

Why Shadow Banking needs to be reined in?

The system of shadow banking seemed to be working fine as banks, other financial intermediaries, borrowers and investors were all happy with the pleasant game of musical chair. However, it appears the music in the game might have stopped as authorities have started issuing warning signals about the risks emanating from shadow banking activities. Regulators are worried about the massive linkage between the banking sector and its shadow counterparts.

The biggest worry is the massive debt pile up in the system (260% of GDP) and significant inter linkages and systemic risk that have got interwoven into the system. Higher leverage and complex, opaque, derivative structures add up to the risk element in case of liquidity freeze. The banking regulators have taken up the task seriously to curtail and control risk emanating from shadow banking activities. The authorities are also struggling to rein in the booming residential real estate prices.

Authorities need to look at the deeper picture and start working towards reforming the financial system. Shadow banking, though widespread, does not necessarily represent adequate financial deepening. Policy change is needed as government policy of directed lending has pushed private commercial enterprises towards shadow banks. Deregulation of interest rates and free flow of capital, credit risk assessment coupled with a satisfactory risk management regime is being called for. Shadow banking should not be left by itself to operate as the market desires, rather it should operate to fulfil the socioeconomic objective of the government. It should be so regulated as to compliment China’s growing economy’s funding needs.