Views on improving the integrity of global capital markets
23 December 2014

Chinese Shadow Banking: Risks and Rewards


I had the opportunity to visit one of Shenzhen’s biggest nonprofit business associations several weeks ago with my friend, Jonathan, a fixed income analyst from Singapore. After some formal in-office discussions with the general manager David, we were driven to a seaside coffee house where the three of us chatted about the latest investment trend brewing in China.

From the perspective of a personal friend, David began by asking us if we would be interested in investing in some capital-protection wealth management product with one of the local banks. Upon hearing terms like “capital protection” and “banks,” Jonathan and I wanted to know more.

David obliged. For a minimum subscription of RMB$1 million, the bank would sign a contract with the investor, guaranteeing a fixed return of 8% per annum, with full capital protection and a one- to three-year term. And for a minimum subscription of RMB$3 million, the bank could offer a better deal — a guaranteed fixed return of 10% per annum, with full capital protection and a three-year term.

Naturally, Jonathan and I were relatively skeptical of such good deals. Shrugging his shoulders, David acknowledged our concerns and told us that precisely because the deals are so attractive, they typically get snapped up the moment they are released. And unless one has a very good working relationship with private bankers, it is virtually impossible for retail investors to participate even if they have the money.

He went on to say that for most retail investors, they would have to make do with capital protection products that come with a fixed return of 4% per annum and a one-year term.

When we questioned how the underlying business model worked, David responded: The banks “take the investor’s money, lend it out to corporations, charge them 15% to 18% interest per annum, pay the investor 10% per annum, and pocket the difference.” He went on to explain that if corporations could not pay up, the bank would sell off pledged collateral to fulfill its obligation to investors, and that was how the bank could offer guarantees on both capital protection and fixed-interest payments.

He also shared that regulators have rendered such explicit guarantees to be illegal for fear of systemic risk. The loophole, however, is that the compliance responsibility only rests with the banks while any contract signed between investors and banks is still recognized by the legal system. In short, while it is illegal for banks to offer such explicit guarantee terms, it is completely legal for investors to purchase it. That is why such products are being sold discreetly and only to high net-worth individuals who have close contacts with private bankers, he explained. This is a good example of the adverse impact of a less robust enforcement regime.

It soon became clear to Jonathan and me that what we were hearing was a pitch for one of the bare forms of shadow banking, where on one hand, you have private bankers who are desperate to hit their sales targets, and on the other hand, investors who yearn for high returns with “no risk.” In between the two parties are small and medium enterprises (SMEs) that are finding it hard to get loans at market rates; hungry for cash, they eventually resort to getting bank loans with exorbitantly high interest rates.

Both Jonathan and I zoomed in on the potential landmines for such a business model:

  1. Value of collateral might drop below par value of loan.
  2. Full capital protection given by a bank is only as valid as the normal operation of the bank. During an illiquidity crunch, would such protection be upheld?
  3. If these banks have a wide depository base and can utilize it to fund these lucrative loans, why are they borrowing from investors at an 8% interest rate when they could source it from depositors at less than 1%?

To date, bankruptcy of a bank has never occurred in modern China (since 1949), even though there are a few near-bankruptcy cases being reported by the media. It is widely hypothesized within the industry that regulators are too in awe of the potential systemic risk to let a bank fail. However, regional banks are testing the limits of central regulators through the moral hazard dilemma. In other words, bankers know their balance sheet will be protected regardless; therefore, nothing is going to stop them from structuring risky wealth management products that have huge domestic demand.

It is not known how big and widespread the capital protection products’ hold is within the wealth management product family, but given the fact that banks are offering 8% per annum for investors’ money, they must have exhausted the legal limit on depositors’ money that could be used to finance the lucrative SME loans. Do note that there is a limit in terms of loan diversification where banks’ loan portfolios cannot be overly concentrated in any one particular sector. This regulatory feature makes sure banks are comfortably cushioned during instances of prevalent loan default that originate from a particular sector.

China is on the verge of revamping its bankruptcy law on banks, and only time will tell what the Chinese regulators have up their sleeves. Until that time, a capital protection scheme with 8% guaranteed return is simply too tempting for investors to pass up and seek capital allocation elsewhere.

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About the Author(s)
Alan Lok, CFA

Alan Lok, CFA, was a director of capital markets policy at CFA Institute. He was responsible for conducting research projects in the area of market instruments and market structures in the Asia-Pacific region. Mr. Lok worked with regulators, institutional investors, academics, and various other stakeholders within the financial industry to uphold investor protection and market integrity.

16 thoughts on “Chinese Shadow Banking: Risks and Rewards”

  1. Joshua Wu says:

    Nice post – I have always been fascinated by the shadow banking system and to be fair it probably played a huge role in China’s rapid rise as the pace of credit growth from this far outpaces that of regular bank lending given the absence of a RRR (reserve requirement ratio in the former). One frequent criticism of the above is that it indirectly encourages wasteful lending and as you quite rightly pointed out, could collapse like a house of cards if a financial crisis hits. Very debatable if an investor would get all his money back if that scenario occurs, legally binding contract with the bank or not.

  2. Alan Lok, CFA says:

    Thanks Joshua for your active participation in my blog posts. Only until we have witnessed an actual case of default will we ever know how things eventually will evolve. Any regulatory body can easily come out with the most robust framework in the universe, but it is still up to effective enforcement to get things right. Time will tell whether taxpayers’ money will again be sacrificed for the “good of all” when that day arrives.

  3. Libra Liu says:

    In China, the shadow banking system you mentioned has long been relying on regulators’ thought of “No Accidents/Defaults Accepted”, which maintains their image and power. As the saying goes, “In China, stability overrides everything.”

  4. Joshua Wu says:

    You are welcome Alan, learning a lot from the posts as well. With regards to the WMP- for simplicity I actually liken them to junk bonds giving high yields , attractive if you can last the distance but theres a real danger of losing your capital in pursuit of higher yields. Like Libra mentioned – its really a bet on the government valuing stability above all else but I think this might not be the case with Xi Jinping and what he has done since he came into power.

  5. Alan Lok, CFA says:

    You are right, Libra! If history is a worthy teacher, preference for stability does seem to override most of the time in China. However, do also remember that there is always a limit on the amount of taxpayer money that can be used to stabilize the system. Beyond that, draconian reforms would have to be implemented to once again achieve a balance of interests among various stakeholders.

  6. Xiang Wang, CFA says:

    Nice post! And it is not just shadow banking, in the bond market where I worked, banks are undoubtly ‘ganrantee’ the credit risk, so it is default free, there is so much gov and bank intervention that produce so much assumption about the bond market. And this is the major problem for SME to raise capital coz banks just won’t lend and underwrite their bonds.

  7. Alan Lok, CFA says:

    Thanks for sharing your personal experience. Given the current momentum of structural reform and the heightened intensity of mass media engagement within the Chinese capital market, it seems to have reached the tipping point where public interest has finally overwhelmed that of vested interest groups during governmental policy formation. It will be interesting therefore to see when and how the bulk of changes will come into picture.

  8. Axel says:

    That sounds like a giant, nation-wide Ponzi scheme. Impossible to avoid a crash once businesses start defaulting on their high-interest loans. If similar collateral then starts to swamp the market because bankers are desperate to sell prior to all other bankers (see 2007 real-estate markets in the US), collateral realisation rates will drop precipitously, creating massive capital holes at the bank level. Only backstop will be the Chinese government trying to continue the track-record of no bank having failed since 1949 (if that is actually true, I do not have any data to judge that statement). Strange that these things re-appear despite the ubiquity of information on the web on similar investment schemes in the past. At least, it sounds like the losses will only be borne by people who can actually afford to lose all of their capital invested in this nonsense…

  9. It sure sounds like these are indeed nearly no-risk investments for everybody but the public. Like you I doubt that intermediaries will be in a financial position to bear any losses. This triggers the questions whether and how problems can be contained when they do arise, which they inevitably will. So far things have been going ok even with schemes like these on the rise. For the time being we will have to follow the old saying, “It doesn’t matter until it matters.”

  10. Alan Lok, CFA says:

    Thanks Axel for your thoughtful narration. I would have a few pointers for your comments:

    1) First of all, the degree of entrenchment of such a product within the Chinese capital market is a big statistical unknown. On whether it will turn out to be a “nationwide Ponzi scheme,” it is still too early to tell. Do remember that the Chinese government can take drastic actions to rectify difficult situations when necessary, and these actions may be unthinkable within the western context, at least not within the typical free market economy.

    2) Most investors in China, and within Asia for that matter, do understand the fact that when things seem too good to be true, they usually aren’t true. Investors know it. To most of them, it is a game of musical chairs where everyone believes he or she would never be the last one standing without a seat. And when you top that with a bank’s guarantee of your principal and interest, you have a perfect storm for moral hazard.

  11. Axel, CFA says:

    Alan, yes, you are absoultey spot on, I was leaving aside the cultural aspects of higher loss acceptance at the level of the individual investors. On your first point, that is what I alluded to by saying that the last backstop will be the Chinese government employing its vast monetary power to rectify a capital loss situation at the level of the individual banks.

    As an aside, apparently some of the hot money collected in China in that way is channelled into European real estate markets, fuelling the irrational run on top-notch locations. Unclear to me how the agents in this trade walk around capital control rules but I guess there are ways. So, to a certain degree, the costs of capital holes in Chinese banks will still be spread around the world. Still looks slightly familiar when compared to 2007…although the overall amounts may be lower.

  12. Alan Lok, CFA says:

    Hi Christian, the tricky part is to react when things happen. If history is a worthy teacher, the whole episode will first need to snowball before things get out of hand. The regulators clearly know what is going on, given the decent amount of media publicity on shadow banking lately, and will most likely do their best to put out the fire before it spreads. We will revisit this issue a year from now. It should be interesting to see how things turn out

    1. Joshua Wu says:

      It seems like we might not have to wait that long. The recent default by Chinese property developer Kasia on a HK400 mio loan with HSBC( the bank seems to be in the news for all the wrong reasons these days ) has had far reaching consequences on the market including WMPs which are more often than not,linked to the real estate industry. For awhile it seems like the offshore bond honders might have dodged a bullet as Sunac offered to buy them out but the latest coming out from them is that severe ” debt modification” is needed in order for the transaction to go through.

      If there is a significant haircut on the bonds ( traditionally considered safer instruments), then WMP holders linked to shadky chinese real estate developers could be in for a rude shock.

      1. I agree with Alan that regulators will make sure troubles don’t spread for as long as possible. This should not be too costly when a HK$400 mln loan is in trouble.

        1. Alan Lok, CFA says:

          Thanks, Christian!

      2. Alan Lok, CFA says:

        Thanks Joshua for the update. If the WMP (wealth management products) that HSBC have offered to investors are capital-protected, the burden would naturally fall on the bank. HK$400 million is not a big amount of money by institutional standards, and the losses related to default in this case are unlikely to be 100%. HSBC would most likely have to bite the bullet. In any case, it will be interesting to see how the bigger picture eventually unfolds.

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