How to cut the cord on China's shadow banks

By John Foley

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)

It’s time for some delicate surgery on China’s financial system. The growth of non-bank lending channels – collectively known as “shadow banking” – is basically helpful for the economy. But regular banks are in too deep. China’s financial regulators need to separate the siamese twins.

Shadow bank activity in China mostly refers to what doesn’t appear on banks’ balance sheets, such as lending by trust companies and wealth management pools. It accounted for $3.7 trillion of credit at the end of 2012, according to Standard & Poors, equivalent to a third of China’s bank loans. These loans are repackaged as short-term products and sold to savers. In theory, rates are set by the market, unlike bank deposits, where low rates are capped by the government.

The problem is that, in China, shadow banking has leached into the mainstream. Regular banks have used their access to cheap deposit and interbank funding, and the assumption that they are “too big to fail”, to sponsor huge quantities of products that are not on their books. In the first ten days of June, banks lent a record one trillion yuan – seventy percent of it in the form of short-term notes that are mostly off banks’ balance sheets, the Wall Street Journal reported on July 2.

That has allowed banks to get around lending quotas, offer savers products with higher interest rates, and earn sales commissions. But it has brought shadow bank risk into the deposit-taking safety net – too close for comfort to regular savings, the lifeblood of the economy.

Two shades of grey

There are two ways shadow bank activities could ping back onto mainstream lenders. The first is through liquidity risk. Short-term products – some lasting just a month – must be refinanced regularly. That’s a problem if the products are being used to finance longer-term loans. If a bank can’t attract enough new savers it might have to use its own cash to plug the hole.

Last month’s spike in inter-bank lending rates was a warning. Some lenders were effectively frozen out of the market, even as some $240 billion of wealth products came due, according to Fitch. In a nightmare scenario, a bank could be so strapped that its ATMs ran dry. The central bank would have to step in, but confidence would be dented.

The solution is simply to prevent banks from being seen as the backstop for wealth products. Investors are already told that if a product fails, they are on their own. But the message will only sink in when a product is allowed to default. Provided regular bank savings were clearly labeled as safe, a wealth product slip-up need not create total chaos. The only alternative is to stop banks from selling wealth products completely.

Hidden dragons

The second channel is credit risk. It’s linked to liquidity: if the ultimate borrower from an off balance sheet vehicle can’t pay back, a bank may be forced to take the loan onto its own books and repay investors, even if technically it was only the middleman. The bank regulator has already told lenders to limit how many credit-linked wealth management products they distribute.

But there’s another fear, namely that lenders may also be hiding direct exposure to shadow credit. One way they do it is through trust products. Banks can arrange for one company to lend to another through a trust structure, with the bank then taking on the credit risk through complex trades with other banks. This can then be classed as an interbank loan.

Such “innovative” interbank activity may have made up 2.7 percent of total loans by the end of 2012, according to CIMB. Rising inter-bank lending rates makes these trades less attractive, but won’t kill them off entirely.

Improved financial stability may come at the expense of economic growth. If banks stop pushing shadow credit, growth would slow, and borrowers who are relying on shadow lending to service real bank debts might go to the wall, causing bad debts to rise. However, that correction is inevitable. The longer the wait, the more painful it will be.

Eventually, China should be able to harness shadow banks for good. They already give a useful signal of what kind of savings rates depositors really expect. A non-bank lending sector where investors understand there’s no free lunch would help channel funds where they’re needed. It may even help pave the way for China to abandon its tightly regulated bank interest rates. That’s a worthy target – but it won’t happen unless the authorities can make that crucial cut.