Practical analysis for investment professionals
10 March 2014

Shadow Banking Is Hurting China’s Banks — And That’s a Good Thing

You’ve read all sorts of warnings about the coming car wreck that is shadow banking in China. Several shadow banking products are reportedly on the brink of default, and the fear is this will have a domino effect in the banking sector, the local economy, and the global recovery.

No doubt shadow banking in China is large (30% of total banking assets, according to JPMorgan’s estimates) and carries unknown risks. But China’s problem is not shadow banking itself, it is a dysfunctional credit system. Large state-owned banks control the bulk of lending into the economy, while the central government sets interest rates and lending quotas. Lending is skewed toward big clients such as large state-owned companies, while small- and medium-size private businesses starve for capital.

How can the world’s second-largest economy function at all? Enter shadow bankers — broadly defined as lenders outside the formal banking system. They include mom-and-pop lending operations, companies lending excess cash to each other, pawnshops, and recently tech companies running money market funds. Unlike shadow banking in the West, shadow banking in China is a necessity, helping build factories, mines, infrastructure projects, and other activities, and creating jobs.

Some analysts worry about the explosion of dubious wealth management products and whether they may be a harbinger of a subprime-like crisis in China. One example is shadow loans bundled together into investment products offering high returns akin to collateralized debt obligations and sold by banks. But what if instead shadow banking in China is the next hotbed of financial innovation?

A Threat to Banks

In the West, banks have become highly risk averse and handcuffed by regulations such that innovation in banking is practically nonexistent. Recent major funding sources such as peer-to-peer lending and crowdfunding websites (which are, broadly speaking, shadow banking activities) emerged from outside the confines of the finance industry and gained ground after the global financial crisis, when trust in banks fell to a record low. The regulatory regime in China is still permissive enough that financial innovation can flourish, so much so that shadow banking is becoming both a threat to banks and a catalyst for faster reforms.

Look at Alibaba’s business model of marrying e-commerce and financing. What started as China’s answer to Amazon has now branched into small and medium enterprise (SME) financing and investment management by offering money market funds with returns of above 6%, higher than the maximum 0.35% deposit rate.

With Chinese savers hungry for higher yields and diversity, and with products being readily available via mobile phones, and with no barriers to entry, it’s no wonder that demand for money market products has surged. In addition to Alibaba, Tencent has jumped on the recent bandwagon. Banks are now countering with their own products.

Ironically, Internet money market funds are lending at high interest rates to banks so they may meet short term payments on bank’s wealth management products. This entire process is effectively leveling the playing field among lenders and liberalizing Chinese interest rates.

Risk vs. Innovation

The spread of Internet financial product delivery to retail clients should be universally welcomed. Yet, the West is very conflicted about this development. Globally regulators are outlawing or restricting commission-based selling models and trying to promote advisory models instead. This is forcing many intermediaries to abandon the retail end of the market, which may well soon be left without advice or services. A self-directed retail market can hardly be in society’s best interest. Regulators so far are extremely unwilling to license Internet-based advisory models (one of the few ways to keep costs down for providers). This is policy incoherence at its worst. Maybe the answers to some of these issues will come out of China.

As long as China’s capital allocation remains inefficient, segments of the population will remain financially marginalized and shadow banking will continue to exist. Chinese regulators seem to tolerate shadow banking activities as a source of financial innovation. Regulations so far are targeted at controlling China’s shadow banking’s rapid expansion, as well as increasing disclosures and transparency to better monitor risks.  Decidedly, the focus is not crushing shadow banking.

At the same time, there’s so much we don’t know about the risks of shadow banking. Investor education is also lacking, with buyers mistakenly believing that these products are risk free. Chinese regulators will have a very difficult task ahead of balancing risk and financial innovation, and this will test the pace of capital market development in China. I can’t foretell if shadow banking will be China’s subprime crisis. But what seems clear is that the biggest casualty of shadow banking could well be traditional banking itself.


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Paul Smith, CFA

Paul Smith, CFA, is president and CEO of CFA Institute. He has more than 25 years of relevant financial services leadership experience in many aspects of the investment management industry.

5 thoughts on “Shadow Banking Is Hurting China’s Banks — And That’s a Good Thing”

  1. China could deflate the housing bubble in a year if it would institute a Land Value Tax. This would tax land, not the buildings upon them, force prices down (as the Land Rent goes up, the Land Price must come down), provide affordable housing to China’s increasingly restive migrant population, and decrease the excess inventory … all while providing real revenues to the government, so it can then remove the deadweight loss of taxes on productive enterprises and income, sales, etc. Perhaps best of all, the Land Value Tax cannot be avoided, offshored, or loopholed out of. All they need is honest Assessors – not guaranteed of course, but certainly possible with the right safeguards.
    – Scott Baker, president of Common Ground-NYC, a Georgist Land Reform advocacy group
    http://www.opednews.com/articles/The-Land-Cycle-and-the-Sto-by-Scott-Baker-130728-228.html

  2. Paul,

    Excellent insights on Chinese Shadow Banking! The CFA Society of Chicago held a conference recently with Even Feigenbaum (The Paulson Institute), Patrick Chovanec (Silvercrest Asset Management) and Andy Rothman (Matthews International Capital Management) which your readers may enjoy covering both the pros and cons of shadow banking (Detailed report here: https://www.linkedin.com/pulse/20141205180753-174377765-chinese-shadow-banking-crisis-or-correction?trk=prof-post)

    I believe the sharp selloffs (12/9/14 and 1/19/15) in Chinese markets on news of tightening credit standards on repo collateral, entrusted loans and infrastructure bonds so how sensitive Chinese markets are to the amount of excess credit in the system. Time will tell if the regulators can reign it in efficiently.

    Thanks again!

    Bob

  3. Jeff Grill says:

    The only thing we know for certain is that the overregulation of financial markets will stimulate significant additional growth within the shadow banking system. This will further magnify growth for mono line finance companies and other buy side players. As far as China is concerned, as noted by PwC* within shadow banking competition will mount and the classic result will unfold. Risk will be mis-priced, poor decisions will be made, and as a result debt will accrue at an accelerating pace. In China, this will lead to a series of failures and potential government intervention. Could it also result in the same level of regulation we see in the capital markets?
    See http://www.pwc.com/cm2020

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