Risk without retention: China's shadow banking system

Credit in China is expensive and often out of reach of small- and medium-sized companies. The huge growth in shadow banking, or non-bank lending, filled the gap and provided lifelines to smaller companies but analysts agree that it poses threats to the world’s largest economy.

Private Debt Investor finds that something that should have supported the economy, now threatens to undermine it.

Statistics on the size of the Chinese shadow banking market vary among institutions but they usually fall in the range of dozens of trillions of Chinese yuan.

Credit ratings agency Moody’s estimates that shadow banking assets reached RMB45 trillion ($7.2 trillion; €6.34 trillion by the end of 2014, representing 71 percent of GDP, compared to 66 percent a year earlier.

“The shadow banking sector boomed three or four years back against the backdrop of the interest rate ceiling imposed by the Chinese government, damping investors’ interest in depositing money in banks while also squeezing lenders’ lines of credit for borrowers,” said Dr. Michael Taylor, managing director and chief credit officer of Moody’s.

The market is largely made up of wealth management products (WMPs), including off-balance sheet bank WMPs and WMPs created by securities firms; entrusted loans; trusted loans and undiscounted bankers’ acceptances. Other minor components include financial leasing, microcredit, pawn shop loans and asset-backed bonds.

With money raised from investors, trust companies usually finance riskier borrowers and transactions that banks cannot undertake due to regulation or shun on the basis of risk. Trust assets are estimated at more than $1.8 trillion, or 20 percent of GDP. While this is only a small part of the total credit in China, these assets have grown at annual rates of over 50 percent in recent years.

Government actions, including the interest rate cap and central government moves to control local authority borrowing, created perverse incentives within the non-bank lending market.

Trust funds also finance local government infrastructure projects via local government financing vehicles, or LGFVs and industrial and commercial enterprises. Following the central bank’s decision to restrict banks’ financing of local governments and property projects, trust companies have become major providers of finance to these sectors.

The most controversial aspect of the shadow banking system centres on the fact that both trust accounts and WMPs are often marketed by banks, creating a false impression that they are guaranteed. Entrusted loans involve lending between companies, creating the potential for a ripple of defaults in the event that one company fails. Also, the underwriting standards and risk management employed by managers of these funds have been called into question.

These issues are familiar, the banks that arranged and repackaged subprime US mortgages benefitted from the fees generated without having to underwrite the risks – which were substantial.

Now the Chinese credit boom, prompted by aggressive stimulus measures by the government in order to shore up the economy following the global financial crisis, has started to take its toll on the economy.

Accordingly to McKinsey & Company, the consulting firm, China’s total debt had reached 282 percent of GDP by the middle of 2014, up from 158 percent in 2007, far exceeding the developing economy average and higher than the United States.

One area of concern raised by the report is China’s local government debt, which is increasingly financed by the shadow banking system through land sales and off-balance sheet LGFVs. These financing vehicles fund infrastructure and other projects, using public land as collateral. By the second quarter of 2014, loans to local government financing vehicles had grown to $1.7 trillion, from $600 billion in 2007. In addition, local governments are also using newer entities, which accounted for an additional $1.1 trillion of debt.

Land sales are employed to repay debt but the sustainability of the huge debt load is in question.

DEALING WITH DEFAULT

In February this year, CITIC Securities, China’s top brokerage said it would seek a legal solution for repayment from a wealth management firm that issue a product that risks default. The high-yielding product, marketed by CITIC, missed a RMB7 million ($1.12 million) payment to investors on 5 February.

Credit experts argue that allowing some default would be positive overall.

Without the safety net of regulation and the deposit insurance systems that go along with it, shadow banking, whether in the West or in China, is inherently more unstable, argues Moody’s Taylor. He points out that in the West, non-bank lending capital comes from institutional investors. “Whereas in China, the funding largely comes from retail investors. The underlying risks in China have less to do with the types of financial intermediaries extending credits but more to do with their risk management capability and capital resources to absorb risks should they arise,” says Taylor. “China should allow a number of companies to default, which is credit positive as it can help accurately determine the pricing of risks of Chinese companies.”

The discredited trust companies declined over the last two years as defaults rose. But new funding channels are coming to the fore and brokerage asset management have increased 43 times in that period.

These brokerages and subsidiaries of mutual fund asset management companies helped push back default risks, but may create even bigger risks in the future, according to a Credit Suisse report published on 17 February.

 

RISK & REGULATION

Aiming to rein in the risks associated with shadow banking, the authorities, including State Council, People’s Bank of China, the China Banking Regulatory Commission, Securities Regulatory Commission and Insurance Regulatory Commission have issued a slew of measures. Previous regulations tended to focus on one particular operation but last year, a more systematic approach was taken.

Non-bank lending managed by entities that have no exposure to the underlying assets has endangered the wider Chinese financial system. Undisciplined lending, whether by banks or alternative providers, is bad for everybody.

The trust fund industry is likely experience more defaults in 2015, but the systemic risks to the financial sector by those defaults are lower than previously thought.

The parent companies of some of the trust firms are state-owned entities (SOE), which could provide a buffer. The booming capital markets will also make the securitization of local debt easier. The swing factor, on just how much the overall market will suffer if bad loans come back to bite, will be the property sector, as many developers do not have SOE parents with deep pockets, according to Credit Suisse.

With state-owned lenders concentrating on financing the large SOEs and letting down the Chinese mid-market, it is little wonder that shadow banking boomed. What China must work towards now is managing increasing defaults while keeping responsible sources of credit open to borrowers. 

 

Trust companies – losing faith

Trust companies are one of the most crucial yet controversial components of the shadow banking market. Contrary to their western counterparts, Chinese trust firms engage in private placement investment banking, providing financing to relatively higher risk borrowers funded by high-net-worth individuals (HNWIs) and corporations/institutions (investors). They are also intermediaries, providing a conduit to banks and other financial institutions that are restricted from investing into certain asset classes or launching certain wealth management products.

Trust companies create WMPs, which banks market for them in return for a commission. The risk with these products is that the arrangers don’t hold these loans on their balance sheets or set aside capital against potential defaults. Instead, banks typically extend the facilities via trust companies, which cannot take deposits or formally loan out money, but are allowed to manage the products.

Trust companies raise money from investors, usually high net worth individuals or companies that meet required wealth standards, of several million renminbi in assets. WMPs are attractive, yields are as high as between nine and 12 percent per annum compared to single digit bank deposit rates. Trust companies charge fees of one to two percent of the loan value and so the ultimate borrower pays around 10 to 15 percent, well above the 7-8 percent for bank loans.