The usually unflappable Fred Hu, founder of Primavera Capital and former Goldman Sachs economist, lost his cool. “Whoever invented the term ‘shadow banking’ should be shot,” he said.
Hu was speaking at a seminar about the risks to China’s financial system and wanted to make the point that shadow banking – which he would prefer to call ‘non-banking lending activity’ – has a useful and necessary purpose. The term ‘shadow’ is pejorative, whereas shadow banking in China provides savers with the means to earn a return above inflation, Hu argued.
The sharp increase in non-bank lending activity in China brings with it risks, however, and while the central government recognises the threat, it needs to act more quickly, said Liu Mingkang. Liu is now a political grandee in China and previously served as chairman of the China Banking Regulatory Commission, as deputy governor at the People’s Bank of China, and as president of both Bank of China and China Everbright Group.
The seminar, organised by the Fung Global Institute and the University of Hong Kong, suggested that shadow banking is a genuine problem but one that the authorities are coming to grips with. It is probably an ephemeral challenge. The real issue is how to instil a proper culture of credit in China’s financial system, shadow or mainstream.
The immediate risk from shadow banking is that this activity is connected to the traditional banking system, and it is unregulated and opaque.
How big is shadow banking?
According to a new study by Oliver Wyman and Fung Global Institute, China’s shadow banking accounts for Rmb31 trillion, including bank off-balance sheet funding, credit guarantees and non-bank lending (for example, private deals between companies).
In some cases banks partner with non-bank lenders. For example, in reaction to incoming risk-based capital rules from the Bank of International Settlements (Basel 3), longer-tenor loans will require banks to hold more capital. Therefore instead of giving a company a five-year loan, a bank will extend a one-year loan and introduce a shadow bank vehicle to provide the remainder of the financing; the bank and the shadow bank entity will share in the fee income.
“The interconnectivity between shadow banks and traditional banks is increasing,” Liu noted.
This could be a problem: recent corporate failures such as Kaisa, with $2.2 billion of outstanding US dollar-denominated bonds, shows how links between different parts of China’s financial system can potentially disrupt others.
Shadow banking is unlikely to get out of hand for four reasons. First, it is largely domestic so, despite episodes such as Kaisa, international spillover is unlikely. Second, China overall remains a net creditor and its sovereign balance sheet is easily in the black.
Third, the government is already taking steps to negate the worst excesses in shadow banking, such as the Ministry of Finance’s new plan to swap many local government’s opaque financial vehicles for lower-yielding but higher-quality municipal bonds.
Fourth, and perhaps most interesting, is the rise of digital peer-to-peer lending platforms, which exist to serve small enterprises throughout the manufacturing supply chain. These companies have been starved of traditional bank lending and had to turn to opaque shadow banks for finance. P2P lending is more transparent and efficient, and growing rapidly. Shadow banking in its current form – often real estate collateral backing high-yield trust products implicitly guaranteed by state-owned banks – may well decline on its own.
Look to the real banks
But the sharp acceleration of China’s shadow banking begs the question of why banks weren’t lending to small private companies in the first place. It is here where the truly difficult work lies.
Clark Anderson, global head of country risk management at Morgan Stanley, said the two fastest-growing shadow banking systems in the world last year were China and Argentina. Argentina has no choice because it has defaulted on sovereign loans and is blocked from traditional international bank financing.
“Why is this China’s company?” Anderson wondered. “Shadow banking operates at the margins of the financial system. A rapid increase in shadow-bank lending implies a reduction in the system’s overall creditworthiness.”
Primavera’s Hu agreed that excess lending has increased non-performing loans for banks offering credit guarantees. In 2008, China’s total outstanding credit was 140% of its GDP; by 2012, it had reached 280% of GDP, making banks more leveraged than in the US. “That suggests we have reached the end of banks’ capacity for debt,” Hu said. Clearly some lending has been reckless and banks’ guarantees of high-yield wealth management products are untenable.
Wanted: credit culture
Liu explained the sharp rise of shadow banking as a response to problems with traditional banks, which prevented them from extending loans to private and smaller companies which are the true drivers of economic growth and employment.
Short-term profit motives make it easy for banks and brokers to cater to state-owned enterprises and local government entities rather than conduct expensive due diligence on smaller companies. Shadow-banking products are also lucrative sources of fee income. Risk-based capital rules have encouraged traditional banks to connive with shadow lenders.
William Overholt, president of the Fung Global Institute and former investment banker, added that smaller companies are also partly to blame because they keep multiple books. “Even if a bank had a good credit analysis system, they can’t adjust for that lack of information,” he said. “Some shadow banks, on the other hand, may feel they know the credit well.”
China’s banks are, in some ways, like global peers, with manager’s incentives misaligned from the roles banks are meant to play in society. Despite many regulatory bodies and rules, international banks engaged in Libor and foreign exchange scandals, among other things, and badly need a cultural overhaul.
But specifically to China, banking remains opaque and lacks a credit culture. Information disclosure must be made robust, said Liu. And banks need to develop a robust culture of lending only when they are confident the loan will be repaid in full, and on time. “Banks must learn to say no,” Liu said. “After all, it’s not their money.” This has to become embedded through corporate governance, transparency and better incentives for managers, rather than enforced via a raft of arbitrary administrative rules.
To get there requires China to speed up its liberalisation programme, Liu said. “We need liberalisation to continue: of interest rates, of exchange rates, and toward the free and full convertibility of the renminbi. That will put pressure on financial institutions of all types because they will need to learn how to manage a balance sheet.”
