Unlike in the U.S., shadow banking in China is dominated by commercial banks, not securities markets. Regulated banks operate most shadow banking activity, take direct risks, provide implicit guarantees and use non-bank entities to shift assets off their balance sheets. That is why China’s shadow banking is called ‘the shadow of banks’ and why it is such a central factor of systemic risk in this highly leveraged economy. China’s shadow banking has important economic functions for individual savers and smaller enterprises. Outstanding ‘shadow savings’ are estimated at roughly 70% of GDP.

Ehlers, Torsten, Steven Kong and Feng Zhu (2018), “Mapping shadow banking in China: structure and dynamics”, BIS Working Papers No 701, February 2018

The post ties in with SRSV’s summaries on shadow banking and, particularly, Emerging Markets/China.
The below are excerpts from the paper. Emphasis and cursive text have been added.

The nature of China’s shadow banking

“[Our] definition…of shadow banking in China [is]… all financial instruments that fulfil functions of credit intermediation typically performed by banks, such as liquidity, maturity, and credit risk transformation, but reduce the burden of or bypass banking regulation… Shadow banking in China has been much more akin to traditional banking: it collects ‘deposits’ or cash from retail and corporate investors, and then transforms their savings into credit of different forms to provide funding to firms.”

“One defining feature of the shadow banking system in China is the dominant role of commercial banks, true to the adage that shadow banking in China is the ‘shadow of the banks’… It differs from shadow banking in the United States in that securitisation and market-based instruments play only a limited role.”

“While much of the expansion during China’s Great Stimulus in 2009-2010 was due to a push for shadow credit growth to ultimate borrowers, such growth has slowed recently. Yet, shadow savings instruments, e.g. wealth management products and trust products…have kept expanding at a rapid pace. At the same time, new and more complex ‘structured’ shadow credit intermediation has emerged and quickly reached a large scale…As a result, the shadow banking system in China has grown more complex.”

On fragility and default risk of the outstanding shadow credit stock view post here.

“To illustrate the structure of the shadow banking system in China, we map the flow of funds from ultimate creditors to ultimate borrowers [in the graphic below]… We distinguish three main stages of shadow credit intermediation…The ultimate creditor stage (right-hand side) is the source of funding, consisting mainly of private and corporate depositors. The most relevant shadow savings instruments are represented by the orange arrows. At the intermediate stage (centre), the received funds are then…transformed into different shadow banking assets. The various forms of shadow credit intermediation generate tight interlinkages (rose and red arrows) among banks and other shadow banking entities. The ultimate borrower stage (left-hand side) is the final destination.”

The key products

“Shadow bank funding in general relies on two main instruments: wealth management products (WMPs) and trust products.

  • Bank-issued wealth-management products serve as alternative savings instruments, which promise higher returns than traditional bank deposits, but are still regarded as safe….Principal- or return-guaranteed WMPs that entail full bank guarantees…are recorded on banks’ balance sheets…[and are not] part of shadow banking….[However,] banks offer non-principal guaranteed WMPs with no explicit bank guarantees, which are not recorded on banks’ balance sheets…Effectively, banks act as asset managers, charging fees to investors, without being subject to regulatory restrictions…Most WMPs are closed-ended, meaning that they have a definite life cycle and investors have to subscribe during specific periods…By the end of 2016, the share of non-guaranteed WMPs in total outstanding WMPs reached almost 80%…
  • Trust products are issued by trust companies which perform credit intermediation functions like commercial banks, but are not subject to the same regulations…Trust companies issue single- or collective-investor trust products, as well as property trust products. Each type is directly linked to the type of shadow credit intermediation that is performed. Single-investor trust products (SITP)…are specifically tailored to the needs of a single investor and typically have either one or a small number of underlying investment assets. Collective-investor trust products (CITPs) bundle funds from various investors and have a larger number of underlying assets…Trust loans and entrusted loans account for the bulk of shadow credit to ultimate borrowers.”

The links between shadow banking and regulated banks

Banks are the dominant players in the shadow banking system. Banks issue key instruments, i.e. wealth management products…Proceeds from issuing wealth management products are largely channelled to non-bank institutions, typically a trust company or a bank’s investment or wealth management arm, and are thereby moved off banks’ balance sheets…[Moreover, banks] are holders of shadow banking instruments or interbank wealth management products…Banks are also the driving force behind the new and more complex forms of ‘structured’ shadow credit intermediation.”

Perceived and actual guarantees are pervasive… By distributing and intermediating a wide range of shadow banking products themselves…banks are perceived as providers of implicit guarantees to their customers in case of defaults, even though they have no such legal obligation…The buyers of wealth management products…typically assume that the distributing bank provides compensation in case of a default…The precedents set by past bail-outs and the perceived priority placed by the authorities on maintaining financial market and social stability contribute to perceptions of implicit bank guarantees. If a state-owned bank is involved, customers may view the products as being ultimately backed by a government guarantee. “

“All types of commercial banks in China, but especially the smaller joint-stock and city commercial banks, are actively and directly involved in shadow credit intermediation. In the process, they create tight interlinkages between formal and shadow banking activities and entities….Proceeds from bank-issued wealth management products, for instance, are channelled into trust products. Further, banks hold TBRs which are participation rights to the proceeds from trust products issued by a trust company…Besides their direct role, banks facilitate shadow credit in various ways. For instance, since direct loans between non-financial firms are legally not permissible, banks act as the trustee and middleman of the so-called entrusted loans between firms. The trustee bank collects the principal and interest and charges a handling fee. It either does not take credit risk in the process, or absorbs part of the credit risk through so-called entrusted rights.”

“More recently, banks have resorted to a combination of existing shadow credit instruments to reduce regulatory burdens. Through this ‘structured’ form of shadow credit intermediation, bank assets are reclassified into investment receivables. Banks can thereby lower non-performing loan (NPL) provisions and alleviate loan-to-deposit (LTD) ratio constraints … The reclassification of bank assets into investment receivables is generating even tighter and more complex and opaque linkages between the formal banking sector and shadow banking entities. In a first step, a bank’s exposures are usually transferred to trust companies or its’ asset or wealth management arms. In return, the bank receives full participation rights in the profits and losses of the underlying loans or debt securities, through TBRs and directed asset management products (DAMPs).”

The size of China’s shadow banking

“Recent estimates of the relative size of shadow credit in China usually focus on the credit provided to ultimate borrowers and broadly range between 15% and 70% of GDP. The wide range is due both to differences in which items are considered as shadow credit and to double-counting. From the ultimate borrower perspective the size of shadow credit in China is not particularly high… The FSB’s 2015 estimates for the total size of shadow banking were 147% of GDP for the United Kingdom, 82% for the United States, and 60% for Japan.”

“The ultimate borrower perspective, however, leaves out important elements of shadow credit intermediation in China. These include WMPs and trust products at the ultimate creditor stage, or the rapidly rising structured shadow credit intermediation driven by joint-stock and city commercial banks…At the ultimate creditor stage, we estimate the volume of outstanding shadow savings instruments at end-2016 at around 71% of GDP, or 46% of total bank deposits.”

The economic function of regulated banks

“Shadow banking serves important economic functions, especially in the form of providing alternative savings instruments and intermediating credit to private firms with less privileged access to formal bank credit.”

“Shadow banking provides credit to private firms which otherwise would be unavailable or too difficult to obtain. As these firms are typically more productive than their state-owned counterparts shadow credit is likely to lead to direct economic gains. Traditionally, most private firms as well as smaller state-owned enterprises have difficulties in accessing the formal credit market, as large state-owned banks prefer to lend to large state-owned enterprises. Banks’ preferences…reflect historical relationships and high creditworthiness due to implicit or explicit government backing.”