Shadow Banking Is Hurting China’s Banks — And That’s a Good Thing

Photo: Xinhua

Photo: Xinhua

Paul Smith | CFA | March 10 2014 – A customer enters a branch of China Construction Bank (CCB) in Chongqing, China, 14 December 2013. Six Chinese trust firms have lent more than 5 billion yuan ($824.6 million) to a delinquent coal company, state media reported on Friday (14 February 2014), raising the prospect of further defaults in Chinas so-called shadow banking system.
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 the brink 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 — broadly defined 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 a harbinger of a subprime-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 a threat to banks and a catalyst for faster reforms.

Look at Alibaba’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 offering money market funds with returns of above 6%, higher than the maximum 0.35% deposit rate.
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