Shadow play: how China's unregulated banks feed its boom and bust economy

More turbulence on the Chinese stock market highlights just some of the challenges facing the world’s second-largest economy. Following losses of US$3 trillion in the three weeks from mid-June, the Shanghai Composite has since recorded its biggest one-day fall for more than eight years. It’s clear that regulatory reform is needed in the country’s financial sector and China’s large shadow banking sector is one area in particular need of government intervention.

Shadow banking refers to the collection of non-bank financial institutions that provide services similar to traditional commercial banks. In particular they provide consumers with credit. But they are not regulated like banks and so are liable of making riskier loans.

China has seen shadow banking grow by more than 30% in the last year. The spiralling growth of this industry in a variety of forms runs the risk of precipitating a financial crisis. It’s important to recognise, however, that the industry has contributed to economic growth amid a global slowdown. The Chinese government will proceed with caution when it comes to regulating the industry.

Costs and benefits

Shadow banking comes with both economic benefits and costs. The up side is that shadow banks can help fuel economic growth by making financial services widely available to a larger section of the population at a cheaper cost. They tend to operate more cheaply than formal banks and therefore provide lower cost loans and other financial services. Shadow banks may also cater to customers that banks cannot or will not serve, especially poorer sections of society.

But this flexibility and price competitiveness often comes at the expense of safety margins. Banks are generally required to have significantly higher capital reserves and liquidity margins than shadow banks may choose to carry, which makes traditional banks costlier but it also makes them safer. Plus, shadow banks often lend to riskier customers or in riskier forms, such as by foregoing the collateral protection that a commercial bank would require. Shadow banks generally tend to operate with much less regulatory supervision, which is designed to curb excessively risky behaviour. In a nutshell, shadow banks tend to be substantially less stable and more risky than banks.

Chinese growth

Chinese commercial banks are under strict government control to pay low interest rates on deposits. There are therefore limited legal investment opportunities for savings and also strict limits on the interest rates charged on loans – hence the rise of alternative channels with higher rates of return.

There is a range of estimates from different analysts on the size of the sector in China. Differences in estimates stem from important variations in the definitions of shadow banking, worsened by the necessity of estimating important statistics as well as nature of the unregulated shadow banking. The following table shows six recent estimates of its size.

Estimates of the size of China’s shadow banking sector.

Most of the apprehensions about shadow banking in China have been concentrated on the activities of trusts. They offer returns as high as 10% and raise money from businesses and individuals who are neglected by the government’s low cap on commercial bank interest rates. The interest that trusts charge to borrowers, naturally, is even higher. They lend to firms that are unable to borrow from banks, often because they are in volatile industries, such as property or steel, where regulators see signs of over-investment and thus face restricted lending from commercial banks.

Entrusted loans are another popular form of shadow banking in China. These involve cash-rich companies, often well connected state-owned enterprises, lending to less well connected firms. For example a state-owned company borrows from a state-owned bank at a government-set low interest rate, maybe 5%. The company then re-lends the money at a much higher rate of return, say 10% or 12%, to a private trust company that is part of the shadow banking sector. That trust company then lends the money into a more speculative part of the economy such as the property market.

But this is not the only way companies are lending to one another. For example, Hangzhou, home to Alibaba and many other industry giants, is one of China’s richest cities, but it is now undergoing a quiet financial crisis. Its many small steel and textile business found it hard to get loans from official banks, so they grouped together and guaranteed one another’s debts, forming a web of entanglements that helped everyone get credit during good times.

But when the economy started experiencing a slowdown, the weaker firms began to default, dragging healthy ones down with them in similar fashion to the securitisation chain that led to the global financial crisis in 2008. Just as a crisis in shadow banking could spread to the real economy, a sharp downturn in some sectors could cause trouble for shadow banks, leading to a broader financial mess.

Balancing act

Given the high growth of shadow banking, regulators are confronted with two major concerns. First that an unregulated shadow banking sector could create excessive credit growth which can lead to financial bubble. And second, that the lack of transparency in the sources and uses of funds can create unmanageable risks for the financial sector. This was seen in the recent stock market collapse.

Chinese regulators must balance the need for shadow banks to supply credit to sectors that are not well served by traditional banks and the need to protect the unregulated sector’s financial stability. It needs to be acknowledged that shadow banking has brought liquidity to smaller businesses and acted as a major catalyst for China’s high economic growth. Taking into account the potentially devastating effects of the bubble bursting, however, the Chinese government should focus on controlling the current situation to minimise the potential fallout.

Nafis Alam does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.