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

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.