In past years China witnessed a boom in shadow finance, particularly in form of entrusted loans. Banks apparently used shadow credit products in large size to circumvent policy restrictions and bank loan regulations. Regulatory tightening has reined in the proliferation of shadow finance since 2014, but outstanding contracts pose serious systemic risk due to the combination of high default risk and dependence on fragile wholesale funding.

International Monetary Fund (2016), “Financial System Vulnerabilities – Shadow Exposures, Funding and Risk Transmission” in “People’s Republic of China – Selected Issues”, IMF Country Report No. 16/271. [IMF]

Chen, Kaiji, Jue Ren, and Tao Zha (2016), “What We Learn from China’s Rising Shadow Banking: Exploring the Nexus of Monetary Tightening and Banks’ Role in Entrusted Lending”, Federal Reserve Bank of Atlanta, Working Paper 2016-1. [FRBA]

The post ties in with the subject of systemic risk related to China’s financial system.

The below are excerpts from the paper. Headings and cursive text have been added.

The core of the problem

“The proliferation of ‘shadow’ credit products and growing reliance on short-term, wholesale funding, could pose substantial risks…Borrower solvency is deteriorating and…defaults on corporate loans by ‘at-risk’ borrowers could potentially imply significant costs.” [IMF]

“Risk to stability may reside in the potential for defaults on widely-held ‘shadow products’ to trigger risk-aversion that results in the withdrawal of liquidity from short-tenor investments in high-risk borrowers. This risk is intensified by financial institutions’ own increasing reliance on short-term wholesale (including interbank) funding, a structure potentially susceptible to rapid risk transmission and destabilizing liquidity events.” [IMF]

What is shadow finance?

“Shadow credit products are investment instruments, mainly with loans or other credit as underlying assets, structured by trust or securities companies, or their asset management subsidiaries.” [IMF]

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“A principal component of China’s shadow banking consists of entrusted loans, a lending activity between non-financial firms with commercial banks or nonbank financial companies acting as trustees or middlemen…Commercial banks in general were prone to engage in channeling risky entrusted loans” [FRBA]

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How large is shadow finance?

Entrusted lending in particular has become the second largest financing source of loans after traditional bank lending. The volume of newly originated entrusted loans reached its climax in 2013. In that year, total shadow lending was equivalent to nearly 34% of total social financing excluding stocks and bonds, and the amount of entrusted lending accounted for nearly 49% of total shadow lending.” [FRBA]

“The volume of…[shadow credit] products grew by 48 percent in 2015, to RMB 40 trillion, equivalent to 40 percent of banks’ corporate loans and 58 percent of GDP.” [IMF]

Banks’ on-balance sheet exposures to shadow products are large and growing fast. At end-2015, banks held RMB 15.2trn of shadow products—equivalent to 8 percent of banks’ assets and 92 percent of capital buffers, and up 58 percent year-on-year for listed banks.” [IMF]

How risky is shadow finance?

“About half of shadow credit products appear to pose elevated risk of default and loss.” [IMF]

“Because [shadow credit-linked] positions appear to be motivated in part by some banks’ practice of repacking deteriorating loans into investment securities to avoid recognizing and providing for nonperforming loans (NPLs), banks’ exposures are likely skewed toward the riskier products.” [IMF]

Although entrusted loans facilitated by nonbank trustees tended to be safe, those channeled by banks ended up in the real estate and overcapacity industries. The incentive for banks to engage in funneling risky loans stemmed from a series of regulatory changes and restrictions imposed on banks.” [FRBA]

Why is it a systemic threat?

“Rapid asset growth has increased banks’ and other financial institutions’ reliance on wholesale funding. From 2010 to 2015, total financial system assets grew by 5½ times more than GDP, twice as much as total social financing and three times as much as loans. Thus while the banking system loan-deposit ratio remained stable, total assets have grown much faster than deposits…The gap has been funded from wholesale sources.” [IMF]

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Banks source about 16 percent of their total funding from the interbank market, up from 8 percent at the end of 2010. Financial institutions, including banks, are in aggregate net borrowers in the interbank market. The funding providers are investment vehicles, mostly structured as ‘wealth management products’.” [IMF]

“Where shadow products differ qualitatively from high-risk loans is in their greater power to transmit risk across the financial system. Of greatest concern are holdings by investors who have little ability or incentive to continue supporting market liquidity in the face of shocks or deterioration in credit conditions. Vulnerable segments include ‘collective’ instruments (RMB 10.9 trillion at end-2015); and holdings by nonbank financial institutions (particularly investment funds), corporates and individuals. Sizing the ‘high-transmission’ segment of the shadow system is difficult; but it appears sufficient to potentially catalyze significant liquidity challenges.” [IMF]

The causes of the shadow finance boom

“The rapid growth of banks’ on-balance sheet exposures to shadow products seems intended in part to exploit regulatory loopholes. Transferring deteriorating loans into securitized packages, much of which ends up on banks’ balance sheets, allowed banks to avoid recognizing these exposures as NPLs, taking loan-loss provision charges to earnings, and including the loans in their loan-to-deposit ratios.” [IMF]

“China’s shadow banking began in 2007, accelerated during the period of monetary tightening after the government’s 2008-2009 economic stimulus, and was then heavily regulated from mid-2014 forward.” [FRBA]

“One unique feature of monetary policy in China is to use monetary aggregates as a major target to stabilize macroeconomic fluctuations. Interest rates were not a major macroeconomic stabilizer until 2014 at the earliest. The main purpose of monetary policy in China has been to control credits and deposits in the banking system.” [FRBA]

“There were two unique regulatory restrictions specific to China’s banking system:

  • the legal ceiling on the ratio of loans to deposits (LDR) imposed by the PBC on each commercial bank…and
  • the regulation prohibiting commercial banks from expanding bank loans to the risky industry…

The LDR regulation, coupled with regulations prohibiting banks from making traditional loans to the risky industry, created an incentive for small banks to bring the risk of shadow loans into their balance sheet through regulatory arbitrage… When the deposit withdrawal risk increases as a result of monetary tightening, the small bank will optimally increase investment in risky assets that are not counted as part of bank loans and thus not subject to the LDR and safe-loan regulations…The small bank, therefore, kills two birds with one stone. The stone is an increase of non-loan risky investment, one bird is the safe-loan regulation, and the other bird is the LDR regulation.” [FRBA]

“One principal component of non-loan investment was in the form of the beneficiary rights of entrusted loans funneled by the banks …What was supposed to be the risk outside the banking system showed up on small banks’ balance sheet.” [FRBA]

“Since 2014 the Chinese government has taken concrete steps to enact and implement a host of new regulations in an effort to close such loopholes. In particular, these regulations prohibit banks from taking risks in entrusted lending either on or off balance sheet, to ban banks from paying higher prices than what regulations allowed to meet deposit shortfalls, and finally to remove the decades-long LDR regulation all together.” [FRBA]

 

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.