Mainland regulators must take quick action to stop the so-called shadow banking problem from snowballing, which has emerged as one of the top threats to the nation's financial stability this year, analysts warn.
Market participants have grown increasingly concerned in the past few months about shadow banking after a bank scandal in Shanghai caused public jitters.
Shadow banking, or underground lending, raises money illegally from the public with promises of high interest rates.
So far, it remains unclear how big the entire shadow banking system is, but it could include trusts, wealth management products, underground finance and off-balance-sheet lending. Some research reports suggested the value could be about 30 trillion yuan (HK$37.3 trillion).
Edward Ding, the chief economist at China Merchants Securities, said one reason it was difficult to get a clear size of the problem was that the official definition of shadow banking was vague. On the other hand, he noted that an overly broad definition could hurt financial innovation, so regulators must exercise care in defining what constituted shadow banking.
"I never believe government regulation can solve all problems. Regulation of shadow banking is only necessary when public interest and the systemic risk of the financial industry are involved," Ding said, adding Beijing should first focus on two types of shadow banking business - high-return wealth management products offered over bank counters and sophisticated trust investment products.
Last month, Huaxia Bank, a medium-sized state-controlled lender, surprised the market with an announcement that a former employee at a branch in Shanghai had sold wealth management products that were not directly issued by the lender. Those products eventually defaulted.
Amid growing protests, the guarantor agreed to reimburse those who bought the product through the bank.
Following the scandal, the banking regulator ordered lenders to tighten checks on third-party products sold through their branches in a bid to step up the regulation of shadow banking. But industry watchers said the regulators should not rely on banks alone for self-supervision.
The risk in bank product defaults is expected to rise this year after new policymakers take office. Beijing is in the course of a leadership transition and more legacy problems from shadow banking might emerge, said David Cui, a strategist at Bank of America Merrill Lynch.
"China's financial stability is likely to face significant headwinds in the form of bad loans coming from shadow banks," Cui said.
Unlike the low deposit rates offered by commercial banks, he said many trusts and wealth management products provided double-digit yields because they were involved in high-risk projects, such as local government-back infrastructure and credit-strapped property developers, which might go bankrupt or pay lower-than-expected returns to investors.
Many private enterprises have been forced to seek funding from illegal lenders because large state-controlled banks prefer to lend to state companies. Such money-lending activities have existed for decades and have proved to be an efficient alternative way of financing small and medium-sized enterprises.
According to Bank of America Merrill Lynch, shadow banking accounts for 25 per cent of overall bank loans, with trust firms and wealth management products representing the biggest segment with a combined 16.9 per cent.
The Huaxia scandal has raised high-level concern about the health of other lenders. Sales of wealth management products surged 43 per cent from a year earlier to more than 12 trillion yuan in the first half of last year, with more than 20,000 products in circulation compared with just a few hundred five years ago.
Andrew Sheng, the president of independent think-tank Fung Global Institute and a former chairman of the Securities and Futures Commission, said: "A common problem with theoretically trained and model-driven banks and regulators is that they tend to assume that what cannot be seen may not exist and what cannot be measured is not important."