The Perils of Chinese Shadow Banking

While China’s banking system has changed drastically over the past 20 years, one fact has remained: Chinese banks remain under the control of the government.

Some of China’s largest state-controlled commercial banks are the Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China and the Agricultural Bank of China. But one recent issue facing the Chinese banking industry pertains to shadow banking, which refers to financial intermediaries that create credit across the global financial system but are not subject to normal regulations. Shadow banks function similarly to traditional banks, except that they can evade the regulatory constraints that state-owned banks are subjected to; however, they are not privy to some of the benefits that traditional banks receive, including publicly guaranteed deposit insurance or lender of last resort facilities from central banks.

For private businesses and entrepreneurs, shadow banks provide a simpler and expedited avenue to loans. However, for the layperson looking to invest, engaging with a shadow bank often means little to no knowledge of the investment vehicle being used. Wealth management products are sold by banks to Chinese investors “with the promise of interest rates much higher than what banks offer for deposits.” However, while traditional Chinese banks sell some or few wealth management vehicles, shadow banks tend to rely on them. Additionally, shadow banking activities are practically off the books, allowing the lenders to evade regulation.

Chen Wenhui, the vice chairman of the China Insurance Regulatory Commission, said that shadow banks offer large returns at proportionally low prices, which attracts laypeople despite not knowing how their money will be invested.

Another form of shadow lending in China is entrusted loans, which are loans from one company to another. These transactions are often conducted through a third-party bank to evade Chinese regulations on companies lending directly to each other. While leaders in this space believe that the risks associated with entrusted loans are manageable, regulatory agencies are skeptical of the methods shadow banks use to raise the money they lend.

Yi Huiman, the chairman of the Industrial and Commercial Bank of China, has taken stark opposition to shadow banking, stating, “If we do not deal correctly with shadow banking, the risks could be huge.” Additionally, Yi noted that shadow banks have given way to “higher leverage, too many derivatives and too many products with no transparency.”

 

Sources:

https://www.nytimes.com/2017/03/18/business/china-economy-debt-shadow-banking.html?_r=0

https://www.nytimes.com/2017/03/18/business/china-economy-debt-shadow-banking.html?_r=0

https://www.brookings.edu/wp-content/uploads/2016/06/shadow_banking_china_elliott_kroeber_yu.pdf

http://www.investopedia.com/terms/s/shadow-banking-system.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186

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9 Responses to The Perils of Chinese Shadow Banking

  1. sackettm18 says:

    So what exactly is the legality of the shadow banking system? I’m confused as to whether these behind the scenes financial institutions actually have a public presence or not. If it is technically legal what is stopping the Chinese central bankers from erecting restrictions to block their actions?

  2. Ryan Curto says:

    I’m also a bit confused of the legality of the Shadow Banking system. I remember Leland Miller touching on the subject during his conversation with us, and what I gathered from his explanation was that Shadow Banks were essentially organizations or corporations, that were not necessarily “banks” in the traditional sense of the word and could even be companies such as Coca-Cola, but would set up novel financial vehicles and unregulated (due to the non-banking nature of the involved parties) lines of credit. In briefly reading though the Wikipedia on Shadow Banks, however, I become confused because the authors refer to financial institutions such as hedge funds, money market funds and other non-bank financial institutions as making up the Shadow Banking system. To my knowledge I thought trade regulators, such as the SEC, surveyed these markets and dealings to ensure responsible and legal financial exchanges. Do Chinese financial regulatory entities have a different set of guidelines, and definition of the Shadow Markets?

  3. gristt18 says:

    I’m really interested by the concept of an “entrusted loan” between two companies. How are interest rates and payment regimes set? I guess implicit in the notion of a shadow economy is that the government doesn’t regulate any of the transactions within it, but is there some untold understanding between companies regarding these questions? Or, perhaps, companies just work out a deal behind closed doors and go from there. If that’s the case, who is enforcing payments?

  4. feldsteinp18 says:

    I think that the emergence of shadow banking as a popular and widespread form of lending could be a cautionary tale for the Chinese economy. As Mr. Miller told us, the Chinese economy is facing higher and higher levels of debt and is simultaneously experiencing a slow down of economic growth. In the US pre-2008, shadow banking became very popular and was one of the reasons for the financial crisis. I wonder what implications this will have in the future and if the Chinese economy does in fact experience a “hard landing” as Mr. Leland predicted, what will happen to these lending institutions?

  5. Alden Schade says:

    I thought it would be interesting to see if any of these “shadow banks” were unable to meet their promises of higher returns than traditional banks, and found this Financial Times article detailing the failure of one such bank to meet promises of 14% returns. It’s a pretty interesting story, particularly for the perspective of the defrauded investors and their response.

    https://www.ft.com/content/82ac1f0e-7ac0-11e4-8646-00144feabdc0

  6. zhengm18 says:

    Similar to Peter’s opinion, Could shadow banking be the correlation with American Wall Street Banks and their excessive leverage during the great financial crisis of 2007? Obviously more factors are at play, but the idea of this underground, unregulated entity with such a massive influence in financial markets is a cause for concern. As 2007 financial crisis shows, unregulated, even legal financial entities can have a dramatic effect on the world economy scale. Professor Smitka has mentioned that China has a problem in local public financing, and the government needs to find an efficient way to legitimately handle this approach. This problem has clearly been exploited by these shadow entities at all levels of Chinese economics. The extent of credit by these shadow banks are unknown, and is definitely a cause for concern.

    • Charlie says:

      This was the first thought that occurred to me as well; any bubble that emerges in the shadow banking market would be nearly impossible for the central bank of China to track. Largely legal lending and securitization practices were enough to nearly annihilate the global banking system in 2008; the potential for a true “wild west” in the shadow banking sector in China is not a prospect that soothes the nerves of those still reeling from the 2008 crisis.

  7. bonesc18 says:

    I think I echo everyone else’s questions on trying to figure out the legal standing here. I can really think of an American model to compare it to, so does this happen in other countries? Is there a model for the effects of shadow banking on the economy, particularly one where the interest rates are influenced so heavily. As suggested above, I guess you could draw comparisons to Wall Street 2007/2008, but that truly doesn’t capture the scale of what’s going on here, it wouldn’t seem. This is certainly a topic I’ve been meaning to read more on since Mr. Miller spoke to our class.

  8. masonw17 says:

    I think that the concern here can basically be modeled as an information asymmetry. The idea of high risk, high reward wealth management practices of the sort offered by shadow banks is by no means new; one could find similar risk/reward ratios in many investment ventures in the US. The issue becomes political, however, when consumers and businesses are not privy to an entire body of information about the risks and potential rewards of investing with a shadow bank relative to an established financial institution. Thus, the Chinese government has two options: eliminate shadow banks entirely or legitimize them enough that consumers can access a reliable body of information about them.

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