Shadow Banking in China—From the Shadows to Center Stage, to the Background Again

Sara Hsu

Shadow banking in China has become an important, closely watched topic. This sector outside of traditional bank loans is relatively large and growing, and there are many risks associated with it, as I have discussed in previous posts (see here, here, and here). However, it is a topic that will soon fade into the background as regulation issues are resolved, the economy declines, shadow banking institutions fail, and financial reform takes place.

When I first began to study this sector in 2006, shadow banking was mainly referred to as informal finance, which encompassed everything in the non-bank financial sector, from pawn shops to private equity firms. Since then, alternative financial institutions have been revived (such as trusts) or have grown in importance (like credit guarantee companies) and begun to overshadow curb lending. China’s economic boom that preceded the global economic crisis was extended by government spending, and increased investment in fixed assets like real estate or plant expansion allowed the boom to continue.

During times of economic growth, financial innovation thrives, in many forms. Loans were extended to real estate developers who were constructing anything from luxury hotels to new cities, to local governments that were building up infrastructure, and to a range of industries. Many funded ventures are now flagging, and the financial sector, particularly the shadow banking sector, is bearing this stress.

As a result, some shadow banking institutions will likely fail as borrowers pass solvency burdens on to them. For example, trust products that have missed payments in the past two years have put considerable strain on trust companies, which have had to foot the bill for these trust loans. P2P, or Internet lending companies have gone under as repayment pressures mounted.

Further regulation will also shrink the shadow banking sector. Although previous proposals to regulate shadow banking as a whole (“Document 9” and “Document 107”) failed to be effective in properly regulating the system, the formulation of the proposals underscores the degree to which regulators are watching the shadow banking sector and the potential risks it may create. As shadow banking institutions fail and risks become baldly exposed, we project that more widespread and effective regulation will follow quickly.

Financial reforms, many of which are expected to begin this year, will also reduce the size of the shadow banking sector. Elimination of deposit rate ceilings, coupled with deposit insurance, will allow depositors to earn more interest on and have more confidence in their bank deposits, and will likely act as a deterrent to demand for higher yielding but riskier shadow banking products. A more market-based system will allow traditional financial channels to compete with shadowy finance.

Finally, as a crisis of economic confidence is provoked—and we have already seen signs of this in the real estate sector—consumers will look to keep their assets safe. They will put their money in bank deposits, keep it in real estate (although they will likely not buy more housing), lend money to their friends for real business transactions, and buy gold or jade jewelry. It is highly unlikely that they will continue to purchase wealth management and trust products that have already shown indications of deterioration, and even less likely that they will lend to companies that already have scarred images, such as credit guarantee companies. The “animal spirits” that played such a large role in creating the shadow banking boom are reversing, and can be depended on to greatly reduce the size of the sector in the coming bust.

I predict, then, that by this time in 2015, shadow banking in China as we know it will be something else, and this buzzword will no longer abound on the mouths of babes. Trust companies will be freshly disciplined and the myriad types of shadow banking entities that exist today will be fewer in number. The financial sector will continue to contain the formal banking sector and many non-bank financial institutions, but the latter will soon be forced to become braver, and less shadowy, than they have been at their commanding height. What a difference a year may make.

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