I wanted to write a follow up to my piece from BloombergViews on shadow banking risks in China with a little more technical focus on a few things. As usual start there, and every thanks to them and my wonderful editor, before coming here.
- Shadow banks is really a catch all phrase for non-bank financial institutions that really encompasses quite a variety of lending types. Trust companies which actually make a couple different types of trust investments. Wealth management products that can both be created and sold by mainline banks as well as on behalf of third party firms. P2P firms which hold little or no capital but act merely as a platform facilitating financial flows profiting by taking some type of fixed fee. There are a myriad of products that are designed in a myriad of ways so talking about this industry as a monolith makes no sense. There are only a couple generalities that are worth mentioning at this point: the products are short term and can cover almost any underlying asset in almost any form from debt to equity.
- Many people think of shadow banks in one area and traditional banks in another but this is absolutely not the case. In many ways, shadow banks and traditional banks are almost indistinguishable from each other. There are two specific ways this happens. First, shadow banks get large amounts of funding from traditional lenders. This happens through a variety of different funding agreements from bank purchases of investment securities from shadow banks to wholesale funding agreements. Bank holdings of the non-loan investment holdings via a number of specific balance sheet line items have exploded over the past few years. Many banks even admit to making large strategic shifts away from direct lending and into these new products. Second, commercial banks even have agreements to act as a distributor or sales staff for shadow banking firms. Consequently, not only are banks purchasing, funding, in some cases directing the funding/locating borrowers, they are then selling for the shadow banks. Even if there is not a direct ownership agreement, this creates an enormous conflict of interest whereby the bank and shadow bank are essentially almost indistinguishable entities. (If you want the best example with details that explain the financing practices I am talking about and the overlap, read this example of China Credit Trust from 2014)
- Mainline banks are engaging in this behavior for two very simple reasons: financial and regulatory arbitrage. Financial arbitrage means banks earn a higher rate of return from lending to shadow banking customers or the shadow banks themselves. Even though lending rates have officially been liberalized, in practice this has not really taken place. There has been little movement in the bank lending rate and customers are not being judged on the risk they present. As an obvious example, local government debt which banks are being forced to buy is trading at yields lower than sovereign. If this debt was not priced at a government mandated price, it would clearly be yielding significantly higher. Banks have even put into IPO prospectuses that they are moving into holding a higher level of these shadow bank products to earn higher rates of returns. Banks that cannot earn what they deem to be a reasonable risk adjusted return are moving into these other products as a Chinese version of chasing yield. Regulatory arbitrage is much simpler. If a bank makes a 100 RMB loan to a coal company, they have to report to the banking regulator that they have 100RMB at risk and set aside the appropriate capital to meet their capital adequacy ratios. However, if they purchase a 90 day security from a shadow bank for 100 RMB, they do not have to set aside anything because Chinese banking regulators allow loans or investment security purchases from financial institutions to have a 0% risk weighting. In other words, a bank can make the same 100 RMB loan but if they make it to a coal company they have to set aside capital but to a shadow bank, they do not need to. This has led to many loans made via trust companies that arrive at a specific company through a trust company that the bank does not weight as a loan because the loan is technically made to a trust company rather than the coal company with the trust company lending the money to the coal company.
- All of this detail leads to a handful of risks. First, shadow banks are intricately linked with the entire financial sector. One way to think of this might be similar to the subprime problem in that there were spillover effects from the non-bank financial institutions to the banks. It is absolutely incorrect to think of Chinese mainline and shadow banks as having some type of dividing line separating them when they are in reality incredibly linked in a variety of ways. The spillover risks are enormous. Second, commercial banks enjoy a variety of privileges their non-bank financial institutions do not such as deposit insurance to state ownership. This provides an implicit government guarantee which shadow banks do not have. It is dangerous for the government and the general investment population from institutions to retail to think of such a neat dividing line given the overlap in funding, sales, and clients. In other words, Beijing will ensure that any type of crisis at a major bank like ICBC never becomes a problem maybe never even heard of. Shadow banks do not have that luxury and could easily trigger liquidity or spillover risks onto the larger banking sector. Third, shadow banks relying primarily on short term funding face very real liquidity risks. If they cannot get new funding every 30-90 days they will collapse. Fourth, the large variety of shadow banks could very easily trigger a bank panic given their widely recognized problems of funding causing liquidity to dry up across the shadow banking sector. This would force Beijing or the banks to step in and guarantee the shadow banks. Fifth, there is a reason that banks are moving so many of their risks off their balance sheets and on to the shadow banks. As the old saying goes: if you are at a poker game and you don’t see a sucker, you’re it. There are amazing cases of banks doing this, some of which they ultimately bailed out but anytime a bank moving risks that fast, pay attention. Sixth, bank risk management practices are weak at best, so you can imagine what the non-bank financial institution risk management practices are like. There are stories almost daily of different shadow banks going bust and private financing disputes were up more than 40% in 2015 with 2016 expected to be another bumper crop for Chinese lawyers. Whether it is straight up fraud or simply non-existent due diligence practices on loans, there is a reason that finance is so much more difficult for smaller players.