In tackling shadow banking, China needs to pick a small target first

PUBLISHED : Tuesday, 29 January, 2013, 8:57am
UPDATED : Tuesday, 29 January, 2013, 8:57am

China’s “shadow banks” have been one of the hottest topics in the financial press lately. Bank of China chairman Xiao Gang, who according to recent rumours would likely take over as China’s top banking regulator soon, has called for tighter regulation. Central bank governor Zhou Xiaochuan has also expressed his concern.

Hand-wringing over shadow banking heightened particularly after the default of an investment product issued by a branch of Huaxia Bank in Shanghai. Despite the fact that clients in the case have been paid back their principal funds in full, many industry observers now worry that various other wealth management products promising high returns may face similar dangers.

But before I weigh in any further with my views on the issue, it’s necessary to clearly define the term “shadow banking” itself. Shadow banks undertake traditional banking activities – deposit taking, lending and often targeting poorer credits and the like – but until now beyond banking regulators’ purview. It’s also safe to assume that they lack a liquidity backstop or credit guarantee from the central bank.

While they are not official banks, shadow banks have to offer the public a sense of security to attract their deposits, offering them the illusion of high quality asset pools, usually created through securitisation or credit guarantees, while denying investors adequate information or the ability to carry out due diligence for themselves.

How and why has shadow banking developed so rapidly in China? For one thing, China’s negative real interest rates and lack of diversified investment tools and products mean savers have to cast their net wider for a return.

Inflationary pressures also increase interest in wealth management products because yields are so low on traditional banking products like deposits. This makes wealth management products the most important funding source for China’s shadow banks.

This, in turn, creates a ‘ratchet’ effect as new wealth management products are created. Because most savers are used to rolling over existing deposits, commercial banks are under pressure to constantly introduce new, more enticing products.

From commercial banks’ viewpoint, a major factor in the development of China’s shadow banking system is unbalanced distribution of credit or funds as a result of strict control of credit by financial regulators. Many enterprises find it hard to raise money through the banking system directly.

Restrictions on real estate loans and loans for polluting or high energy-consuming industries force these enterprises to seek funding from shadow banks. This is, in essence, a kind of “regulatory arbitrage”.

To some extent, shadow banking supplements real banks, and helps allocate funds more efficiently, so it’s not all bad. It comes down to regulation: if banking is defined too broadly, financial innovation may be hindered. Overly tough financial rules lie at the root of regulatory arbitrage worldwide.

For its part, the Chinese central bank has recently laid out a long list of what it considers shadow banking:

-- commercial banks’ off-balance-sheet wealth management;
-- the collective wealth management of securities companies;
-- separately managed accounts of fund management companies;
-- securities investment funds;
-- the investment accounts of unit-linked insurance;
-- industrial investment funds;
-- venture capital funds;
-- private equity fund;
-- enterprise annuity;
-- housing funds;
-- micro-credit companies;
-- bill discounting companies;
-- third party payment companies with stored-value and prepayment mechanisms;

But is it practical to try to tighten the reins on all of these fronts at once?

I have never believed that government regulation can solve all problems.

In my opinion, regulation of shadow banking is only necessary when both the public interest and systemic risk are involved. That is to say, regulation is needed when shadow banking products are packaged into a kind of term deposit or when some shadow banking products may upset the stability of the financial system, and affect the broader economy.

For these reasons, I suggest the regulators should initially focus on high-yield wealth management products offered at bank counters or through trust companies. Many banks have aggressively promoted those products to clients who may not be fully aware of the risks involved. This will sooner or later blow up into crises when clients realise, or even just suspect, that their investments are in trouble, just as what happened to some Huaxia Bank customers in Shanghai late last year.

So far, as much as 60 per cent of assets in those high-return wealth management schemes I mentioned above are invested in low-risk, interest-rate products and bonds, and the rest is mainly invested in the money market. While these are not high-risk products per se, stricter regulation is needed because of transparency problems with some products. For example, a single short-term product may comprise long-term assets such as bonds and bills and trust plans.  There is high possibility of asset-liability mismatch and maturity mismatch, and at certain point the equation will be broken. In financial terms, the default occurs.

There is no such thing as a free lunch. This definitely includes high-yield trust products – no matter how they are marketed to you. Trust assets have ballooned since the government put the squeeze on bank lending in 2011. While we have not yet seen any defaults in these trust products, the question must be asked: how long will people buy into the myth of investment products offering 10 per cent annual returns, risk-free?

Looking forward, the appointment of new leaders at the PBOC and the three financial regulatory bodies -- China Banking Regulatory Commission, China Securities Regulatory Commission, and China Insurance Regulatory Commission – may see the new bosses uniting to strengthen supervision of shadow banking. I expect the recent flood of media coverage to help goad CBRC and the PBOC to fast-track regulation – as I suggest – among all things that fall into the long PBOC list of what shadow banking business means, the regulators should first simply focus on one thing, those higher-return wealth management products offered at commercial banks and trust firms.

Edward Anhua Ding is executive vice president and chief economist of China Merchants Securities.