Will shadow banking destabilise China’s financial system?

The rapid growth in shadow banking activities in China is making investors and creditors apprehensive. Standard & Poor’s Qiang Liao explains why these activities have far-reaching credit implications for China’s economy and financial system.

How big is China’s shadow banking system?
We estimate shadow banking accounts for Rmb22.9 trillion (or $3.7 trillion) of credit in China as of the end of 2012 after making adjustments to avoid double counting. That’s equivalent to 34% of the total loans in the banking sector, representing 44% of China’s GDP in 2012. Let’s contrast these figures with those for G20 countries and the eurozone (or the European Economic and Monetary Union). The Financial Stability Board estimates the aggregate for these regions at 111% of their total GDP as of the end of 2011.

What is shadow banking?
Standard & Poor's defines shadow banking as “credit intermediation involving entities and activities outside the regular banking system.” which is in-line with the Financial Stability Board’s definition. In China, we view the central bank and all depositary institutions as the regular banking system. These depositary institutions include policy banks, commercial banks, credit cooperatives, and licensed finance companies. The institutions are under the supervision of China’s banking regulator, which produces various statistics that record their exposure to the “real economy” — the part of the economy that involves the production of goods and services.

In our view, credit intermediation activities should be considered as shadow banking only if the credits add to leverage in the real economy or the financial system and are not properly accounted for as regular banking credits. We therefore exclude all traditional off-balance-sheet credits (such as letters of credit, bankers’ acceptances, bank guarantees, and committed credit lines). That’s because these contingent credits don’t push up leverage in the real economy until they are drawn down, while bank capital ratios already capture their impact on leverage in the financial system.

Shadow banking has grown at a rapid clip in China. We estimate credit in this market has increased at a compounded annual growth rate of 34% since the end of 2010. And growth is likely to remain strong for the next few years, at least, albeit at a slightly slower rate.

What’s led to such rapid growth?
Three key factors have fueled the expansion in shadow banking since 2008: massive investments in infrastructure and property development, consolidation in China’s export sector, and restrictive measures in the banking system.

Why do Chinese banks participate in shadow banking activities?
Regulatory arbitrage — or circumventing regulatory measures — is a common theme behind shadow banking activities globally. It’s particularly pertinent in China, given that the government regulates interest rates, sets steep deposit reserve ratios (20.5% for major banks), and imposes conservative loan-to-deposit requirements (capped at 75%). The central bank also intervenes in loan growth by setting banks quotas for new loans.

Market competition has encouraged banks to seek loopholes in regulations by making loans and attracting deposits via wealth management products and other unconventional channels (such as loan-backed repurchase agreements with nonbank financial institutions).

An underdeveloped bank-performance culture has also boosted shadow banking. The banks have used wealth management products and other off-balance-sheet credits to increase headline profitability and diverse their revenue mix. In addition, many banks opted to extend credit to liquidity-thirsty clients through the shadow banking market, at a time when the regulator was focused on reducing nonperforming loans in the regular system.

How risky are the underlying credits in China’s shadow banking system?
A common misperception about China’s shadow banking is to assume the underlying credits are equally risky. In our view, they have very different risk characteristics.

Several areas of shadow banking in China could be highly risky. These include trust credits to property developers and the financing companies of local governments, and curb-market loans to distressed property developers or export-related small to mid-size enterprises. A common characteristic of these borrowers is that they have restricted access to bank loans because of either weak credit profiles or unfavourable credit-rationing measures that the government has imposed.

We believe more than half of shadow banking credits in China could have better risk levels than bank loans. Specifically, most wealth management products that banks originate are higher-cost funding alternatives to deposits. The underlying assets of these products therefore tend to have a short maturity of less than six months and adequate quality to minimise default risks.

What about the risks to the banking sector?
Chinese banks could face risks to their transparency, compliance culture, liquidity management, and profitability. The potential for regulatory arbitrage perpetuates the opaqueness about shadow banking undertakings. Banks have made limited disclosure, if any, about their mix of wealth management products or the composition of the underlying assets. Statistics are scarce about certain parts of shadow banking, such as curb-market lending or wealth management products that nonbank companies originate.

Distorted growth in China’s shadow banking system could lead to an unintended build-up of credit risks that banks may not fully appreciate. First, for most bank-originated wealth management products, credit risks are barely transferred to investors — even though investment contracts suggest otherwise. The banks are exposed to reputational risks if they don’t bail out investors in loss-making wealth management products that they originated. Second, banks could be understating their credit exposures if they disguise their corporate loans as investments in other banks’ wealth management products. Finally, the banks remain exposed to contagion risks or collateral damage stemming from credit defaults in the shadow banking market. A borrower in this market often remains a direct or indirect debtor of the regular banking sector.

Is shadow banking destabilising China’s financial system?
Not yet. Our view reflects several factors:

  • the modest size of shadow banking relative to the regular banking sector;
  • the risk characteristics of various shadow banking products;
  • the banks’ position in taking credit losses from third-party originated wealth management products; and
  • the sector’s current financial metrics, including capitalisation, earnings, and funding profiles.

In general, we believe major Chinese banks’ capitalisation, earnings, and liquidity profiles provide a comfortable buffer to absorb any possible hit from shadow banking and credit risks in the wider Chinese economy.

We view China’s shadow banking more as a symptom than a cause of some emerging systemic risks to the banking sector and the wider economy. The sharp rise in the leverage of the Chinese economy mainly occurs at the financial vehicles of local governments and property developers, and is primarily fueled by bank loans. The credit exposure to these segments by the regular banking sector is already high, which we view as a major threat to China’s financial system. When the central government has attempted to contain the risks, shadow banking has boomed and continued to fuel excessive expansion among these entities.

7: How does Standard & Poor’s define shadow banking?
We define shadow banking as “credit intermediation involving entities and activities outside the regular banking system.” which is in line with the Financial Stability Board’s definition. In China, we view the central bank and all depositary institutions as the regular banking system. These depositary institutions include policy banks, commercial banks, credit cooperatives, and licensed finance companies. The institutions are under the supervision of China’s banking regulator, which produces various statistics that record their exposure to the “real economy” — the part of the economy that involves the production of goods and services.

In our view, credit intermediation activities should be considered as shadow banking only if the credits add to leverage in the real economy or the financial system and are not properly accounted for as regular banking credits. We therefore exclude all traditional off-balance-sheet credits (such as letters of credit, bankers’ acceptances, bank guarantees, and committed credit lines). That’s because these contingent credits don’t push up leverage in the real economy until they are drawn down, while bank capital ratios already capture their impact on leverage in the financial system.

 

The author of this article, Qiang Liao, is a Senior Director of Financial Institutions Ratings at Standard & Poor’s.

 

Print Edition

FinanceAsia Print Edition

CONFERENCES