Shadow banking has grown quickly in China, driven by regulatory arbitrage and the growing role of non-bank financial institutions in the financial sector. In this episode of Pacific Exchanges, we sat down with our colleague Cindy Li to discuss her recent paper on shadow banking in China.
Some of the key takeaways from our conversation with Cindy include:
Welcome to Pacific Exchanges, a podcast by the Federal Reserve Bank of San Francisco. I’m Nick Borst.
And I’m Sean Creehan. We’re analysts here in the Country Analysis Unit at the San Francisco Fed. And our job is to monitor financial and economic developments in Asia.
Today we’re going to talk about shadow banking in China. This is a topic that gets covered a lot in the media. But, there may be a lot of confusion out there on what exactly we mean when we talk about shadow banking.
I think there are a lot of questions about what exactly is shadow banking in China. How does Chinese shadow banking differ from shadow banking in other countries? And what are the risks that shadow banking presents to the financial system as a whole?
So to learn more about this, we sat down with our colleague, Cindy Li. Cindy is a senior China analyst here in the Country Analysis Unit, and an expert in various Chinese financial sector issues, including shadow banking. She’s been following this issue for the last five-plus years, and has recently released a new report on the subject, which you can find on our Asia Program website.
So without further ado, let’s listen to our conversation with Cindy.
Well, thanks for joining us Cindy.
Thanks for having me.
So Cindy, you recently wrote a paper on shadow banking in China. I’m wondering if you can start by telling us, what is shadow banking, and why is it unique in China?
This sounds like a simple question, but it’s actually a very complicated one. So, shadow banking is a widely discussed, but actually loosely-defined concept. Broadly speaking, it can be described as credit intermediation outside the banking system. So, when a financial institution conducts credit intermediation, it uses short-term funding to fund long-term assets. So this is something that we call ‘maturity transformation’. And it uses liquid liabilities to buy illiquid assets, such as loans. It uses leverage and takes credit risk when a borrower cannot make good—it’s his obligation. Banks do this every day. But sometimes, a non-bank performs the same function, but they are not supervised aspects. They probably do not have access to the banking system safety net. Then, this is a very good example of shadow banking.
So in the U.S., people think of shadow banking in terms of securitization, special purpose vehicles, these types of structures. What specifically does shadow banking look like in the Chinese context?
I think that you are right. In the United States, when you talk about shadow banking, you think about money market mutual funds, asset-backed commercial paper, securitization, and GSEs. But shadow banking actually looks very different across countries, and at different points of times. But they all have to do with circumventing banking regulation to obtain higher returns. So, in the case of China, the shadow banking structure is still relatively simple. Trust companies are the main players, which is quite different from the rest of the world. But this may be changing soon, as money market funds, asset-backed commercial paper, and internet finance companies are gaining importance.
So from the name ‘shadow banking’, you might think that we don’t know much about this field. How transparent is shadow banking in China? I mean, how’s the data look? What do we know about it?
So, for shadow banking—I guess, this is not just a problem for China, but for shadow banking all over the world. There is the concern that there’s a lack of disclosure and information that people can use to gain insights into the nature of these products, and to better understand the credit quality associated with shadow banking. So, these shadow banking activities are lightly regulated at best, sometimes unregulated, and only come with very limited disclosure requirements.
So, after the global financial crisis, the international community, led by the Financial Stability Board, has paid a lot of efforts to collect data regarding shadow banking systems, so that we can understand them better. In China’s case, I think we have made a lot of progress towards better understanding shadow banking activities. So, many private sector analysts started to write about shadow banking after 2013. Then, there is also a growing body of academic literature that documents the growth of China’s shadow banking system, and modeling shadow banking entities’ behaviors. So I will say that we know better. We know more about them today, definitely, than what we did in 2013.
You talk about behavior. What drives the behavior?
The short answer is regulatory arbitrage. But let me elaborate on that. If you look at Chinese banks, so they operate in a tightly regulated environment, they’re subject to many prudential requirements imposed by the regulators. So some of these requirements are quantitative, such as a loan-to-deposit ratio of 75%, that the regulators have strictly enforced until 2015. So, some are qualitative; the regulators are saying you cannot really continue to expand—to extend credit to high-risk and overcapacity industries. And also, restrictions on bank deposits and lending risks before 2015. That was also a key factor behind the rapid growth of shadow banking.
So to circumvent interest rate controls, banks issued something called ‘wealth management products’. So, these are, essentially, an alternative to bank term deposits, but offer market-determined higher returns. This led to sharp increases in funds flowing to the shadow banking system. Then, from an investor’s point of view, they are constantly looking for higher return on their investment.
So, in China’s case, households have limited investment options, since it still has a growing capital market. So, wealth management products are an attractive option for them. And also, many economists believe that shadow banking has filled a vacuum that formal financial system was not able to fill. So shadow banking basically helps improve access to credit to China’s underserved private sector. Especially the small and the medium enterprises. So, in a sense, you can even argue that the rapid growth of China’s shadow banking system was allowed by the policy-makers, to ensure that credit flows to the real economy.
Now Cindy, circling back to look at wealth management products, for people who follow the Chinese economy closely, they’ve probably noticed how quickly these have been growing. Can you just give us a sense of how big wealth management products are, maybe relative to the size of total deposits? And then, what types of things are they investing in? And what are the risks from so many savers putting their funds into these products, as opposed to traditional bank deposits?
So, wealth management products are a major source of funding for China’s shadow banking system. They grew by 80% from the end of 2014 to Renminbi 27 trillion, more than U.S. 4 trillion, in the third quarter of 2016. And now, they are equivalent to one-fifth of bank deposits in China, which is a lot. A portion of wealth management products are invested directly in loans, which means they firmly fit within the definition of shadow banking. But banks are also directing a growing share of wealth management products into capital market securities, such as stocks, bonds, and money market instruments. So instead of directly evolving credit extension—so this part of funds, indirectly funds credit extension. And it adds more layers to the credit intermediation chain.
And I understand, with these wealth management products, that many are off balance sheet for the banks, but there’s still a widespread belief among investors that banks will stand by and honor these products.
So, that is something that China analysts typically call ‘implicit guarantee’, I guess. And yes, there is a widespread belief that even if—even though these wealth management products are different from bank deposits, banks will still guarantee these products. And, that is—that carries certain risks, because investors will underestimate the riskiness of these products. So the pricing of these products may not accurately reflect the quality of underlying assets.
So to help some of our listeners understand, if they haven’t heard of a wealth management product before, is it analogous to something like a money market mutual fund? More like, just a general mutual fund that someone might invest in here in the United States? I mean, how would you think of it, as a saver in another country?
I would describe it as—so it’s not entirely similar to money market mutual funds, in the sense that a large chunk of wealth management products are still on bank’s balance sheets, so they are not necessarily independent investment conduits. They are—they can essentially be thought about as a shadow deposit, or a higher-yielding alternative to bank deposits.
So you’ve been covering this topic for a while now. You mentioned that since 2013. And I know your recent report is an update on your previous studies. But how has shadow banking evolved over the last 4 years since you first really started following this topic closely?
So, it grew a lot bigger, and it’s getting more complicated. So the shadow banking system really reacts to changes in policies and regulations. And they are constantly evolving as the financial reforms close regulatory loopholes and capital markets grow in depth and sophistication. So, compared with 2013, when shadow banking first became a regulatory focus, China’s shadow banks now play a reduced role in directly funding the real economy. So banks are directing a growing share of funds into capital market securities, as I mentioned, including stocks, bonds, money market instruments. So, right now, shadow banking system has a growing interconnectedness with the formal financial system. But they add to the credit intermediation chain, rather than directly fund the real economy.
The system is also increasing in complexity. So one example is trust beneficiary rights. I think, Nick, you are familiar with this concept. So a bank can transfer part of its loan books to a trust company, but it buys back the right to receive income stream from the loan. And the bank still retains all credit risks by providing guarantee to the loan. So this is essentially a form of shadow credit. But, banks record them as investment receivables to circumvent regulatory requirements.
So this is when things get interesting. Trust beneficiary rights now have a growing secondary market. And in some cases, trust companies were repackaging these products into different trenches. So they are effectively securitizing these products. A similar product called ‘directional asset management plan’, DAMP, is also popular among banks as a way to extend credit with securities firms.
So I think, going forward, there will be more profound changes in the way. So, as of 2015, China’s money market mutual funds has roughly 700 billion U.S. dollars. And management, asset-backed securities, and the repo markets are also rapidly growing. So, new types of investment conduits and structured products are emerging. And they can potentially gain a much larger role in shadow banking system. Which means, China’s shadow banking system will still become bigger, more complex, and may start to look a lot like the U.S. shadow banking system today.
Cindy, you do a great job in your paper highlighting how shadow banking has moved away from the real economy to become more interconnected with financial institutions. Two questions on this point. Is it now more difficult for regulators to monitor shadow banking due to the increasing complexity? And number two, if we do see problems in shadow banking products, is it going to be more difficult to resolve now that there’s more interconnection between different financial institutions?
That’s a great question. And I think, given that this is still an evolving concept, it’s true that, for regulators and analysts, one big challenge is to constantly monitor the current development in the shadow banking system. Actually, over the years, Chinese regulators have issued a number of regulations. So some focus on closing the regulatory arbitrage loopholes. And some focus on putting restrictions on shadow banking activities.
So, some examples, in 2015 the banking regulator, the CBRC, changed the loan-to-deposit ratio from a regulatory requirement to an observed indicator. So that, nominally at least, eliminated the incentive for banks to engage in—to disguise loans as investments or off-balance-sheet obligations. Another example is, in December 2016, the PBOC announced that it will start to include off-balance-sheet wealth management products into its risk assessment framework in 2017. And that means banks will likely need to set aside capital for these activities.
Then, moreover, the CBRC has introduced tighter underwriting standards, and some requirements on capital and leverage for trust companies. And CBRC has also proposed a maximum leverage ratio for bank-issued wealth management products. So, a lot is going on.
So, one of the issues that emerged in the global financial crisis here in the U.S., was that there was diffuse regulatory responsibility, that a lot of these shadow banking activities were under the responsibility of multiple different regulators. And so it wasn’t clear who was the leading actor for each item. Is that an issue in China? Do we see that shadow banking activities cross across different regulatory jurisdictions?
Yes. And I think that’s a lesson countries around the world learned very well from the global financial crisis. So, I do not think there is a best practice with regards to how regulators should regulate shadow banking industry. Should there be separate regulators for each entity? Should there be a regulator—umbrella regulator, that takes care of all kinds of shadow banking entities? I do not have an answer for that. I do know this is a work in progress. And judging from recent developments in China’s capital markets, there is definitely a case for enhanced cooperation among regulators. And I also think that’s one direction that Chinese regulators are putting efforts in.
So you, earlier, talked about, one of the drivers of the growth of shadow banking is demand for credit from SMEs that, perhaps, earlier in China’s financial development, were being served by the banking system. Is the decreased role of shadow banks in funding the real economy a reflection of an increase in credit from other sources for SMEs? Is that part of the story here?
That’s definitely part of the story. So the background is that China has a growing capital market, and direct financing, such as bond issuance and equity issuance, that is really picking up over the past several years. So, I anticipate that, if the bond market continues to grow, and more small and medium companies find their way into the capital markets, then shadow banking’s role directly supporting the real economy may continue to shrink.
One of the things we’ve followed very closely, particularly on this podcast, is the development of FinTech in Asia. Lots of new innovations being experimented with. How do you draw a line between financial innovation and shadow banking? You know, is something like peer-to-peer lending is—would that be considered shadow banking?
The short answer is, we may not be able to draw a clear line. Take the FinTech, the peer-to-peer lending company example that you just mentioned. In a perfect world, a P2P lending platform does not engage in maturity transformation, it doesn’t do liquidity transformation, and they do not use leverage. In reality, there are a lot of gray areas, of course. So, for example, when P2P lenders start to develop standardized secondary markets to provide liquidity to their investors, or if they decide to package underlying loans into different trenches, then things start to look a little like securitization and shadow banking. So, the reality is that, given shadow banking’s regulatory arbitrage nature, shadow banks will always explore innovative funding models. And financial innovations are means, not an end.
So, from a regulatory point of view, I guess, the key is always to identify sources of risks. But sometimes, it’s hard to put everything in a very well-defined framework. Especially when something like shadow banking system is constantly evolving.
So you’ve talked with us about the evolution of shadow banking in China over the last four or five years. Maybe we can end with a prediction from you on how you think things will look four to five years from now?
I think right now, China’s shadow banking accounts for roughly 8% of global shadow banking assets, according to Financial Stability Board. I think the number will still grow. So anticipate constant growth. Anticipate more complexity in the system. But also, as China makes steady progress in liberalizing its capital markets, I think the relative importance of direct finance will increase, and shadow banking may start to play a lesser role.
Well great, thank you so much Cindy. We’ll look forward to following your work on this topic in the future.
And I look forward to following this line of work as well.
For more episodes like this, you can find us on iTunes, Google Play, and Stitcher. For even more content, look up our Pacific Exchange blog, available at frbsf.org. Thanks for joining us.