Shadow Banking Is Hurting China’s Banks — And That’s a Good Thing
ByPaul Smith, CFA
Categories:Economics,Portfolio Management,Risk Management,Standards, Ethics & Regulations (SER)
You’ve read all sorts of warnings about the coming car wreck that is shadow banking in China. Several shadow banking products are reportedly on thebrink of default,and the fear is this will have a domino effect in the banking sector, the local economy, and the global recovery.
No doubt shadow banking in China is large (30% of total banking assets, according to JPMorgan’s estimates) and carries unknown risks. But China’s problem is not shadow banking itself, it is a dysfunctional credit system. Large state-owned banks control the bulk of lending into the economy, while the central government sets interest rates and lending quotas. Lending is skewed toward big clients such as large state-owned companies, while small- and medium-size private businesses starve for capital.
How can the world’s second-largest economy function at all? Enter shadow bankers —broadlydefined as lenders outside the formal banking system. They include mom-and-pop lending operations, companies lending excess cash to each other, pawnshops, and recently tech companies running money market funds. Unlike shadow banking in the West, shadow banking in China is a necessity, helping build factories, mines, infrastructure projects, and other activities, and creating jobs.
Some analysts worry about the explosion of dubious wealth management products and whether they may be aharbinger of asubprime-like crisis in China. One example is shadow loans bundled together into investment products offering high returns akin to collateralized debt obligations and sold by banks. But what if instead shadow banking in China is the next hotbed of financial innovation?
A Threat to Banks
In the West, banks have become highly risk averse and handcuffed by regulations such that innovation in banking is practically nonexistent. Recent major funding sources such as peer-to-peer lending and crowdfunding websites (which are, broadly speaking, shadow banking activities) emerged from outside the confines of the finance industry and gained ground after the global financial crisis, when trust in banks fell to a record low. The regulatory regime in China is still permissive enough that financial innovation can flourish, so much so that shadow banking is becoming both athreat to banksand a catalyst for faster reforms.
Look atAlibaba’s business model of marrying e-commerce and financing. What started as China’s answer to Amazon has now branched into small and medium enterprise (SME) financing and investment management by offeringmoney market fundswith returns of above 6%, higher than the maximum 0.35% deposit rate.
With Chinese savers hungry for higher yields and diversity, andwith products being readily available viamobile phones, and with no barriers to entry, it’s no wonder that demand for money market products has surged.In addition toAlibaba,Tencent has jumped on the recent bandwagon. Banksare nowcountering with their own products.
Ironically,Internet money market funds are lending at high interest rates to banksso they maymeet short term payments on bank’s wealth management products. This entire process is effectively leveling the playing field among lenders and liberalizing Chinese interest rates.
Risk vs. Innovation
The spread of Internet financial product delivery to retail clients should be universally welcomed. Yet, the West is very conflicted about this development. Globally regulatorsare outlawing or restricting commission-based selling models and trying to promote advisory models instead. This is forcing many intermediaries to abandon the retail end of the market, which may well soon be left without advice or services. A self-directed retail market can hardly be in society’s best interest. Regulators so far areextremely unwilling to license Internet-based advisory models (one of the few ways to keep costs down for providers). This is policy incoherence at its worst. Maybe the answers to some of these issues will come out of China.
As long as China’s capital allocation remains inefficient, segments of the population will remain financially marginalized and shadow banking will continue to exist. Chinese regulators seem to tolerate shadow banking activities as a source of financial innovation. Regulations so far aretargeted at controllingChina’s shadow banking’srapid expansion, as well asincreasing disclosures and transparency to better monitor risks.Decidedly, the focus is not crushingshadow banking.
At the same time, there’s so much we don’t know about the risks of shadow banking. Investor education is also lacking, with buyers mistakenly believing that these products are risk free. Chinese regulators will have a very difficult task ahead of balancing risk and financial innovation, and this will test the pace of capital market development in China. I can’t foretell if shadow banking will be China’s subprime crisis. But what seems clear is that the biggest casualty of shadow banking could well be traditional banking itself.