Shadow banking systems, comprised of non-bank financial intermediaries that operate outside of financial regulations to provide similar services to commercial banks, have become increasingly common in China. This is the world’s second largest economy, where banks are controlled by big government and have been notoriously hesitant to lend to private businesses.
But by sidestepping regulation to work through hedge funds, money market funds, and other structured investment vehicles, Chinese lenders are putting many of its commercial banks at risk. This article discusses current shadow lending practices in China, and the risks involved.
The Financial Situation in China
The rise of unregulated investment vehicles has been attributed to keeping financial obligations off bank balance sheets at the expense of higher interest rates. Internet lending platforms have been raising a significant amount of public money by encouraging small contributions and promising big returns. Chinese wealth management products held in off-balance sheets have increased dramatically, which is upsetting economic stability in the short term with questionable long-term consequences as well. Meanwhile, Chinese officials have been supporting policies to prevent an economic slow-down, thereby expanding credit and largely focusing on real estate.
Chinese lending companies have insisted that they understand the risks involved in shadow lending and are prepared to change courses in the future if necessary. Yet economic critics worry that high leverage, too many derivatives, and inadequate transparency pose huge risks that should be dealt with at the present time.
The Dangers of Shadow Lending
One of the most important factors to consider when discussing shadow lending is where specifically in a bank’s infrastructure a failed shadow lending scheme threatens damage to the institution. Most commonly, issues arise when investors begin to question what long-term assets are worth and withdraw their funds all at once.
This phenomenon forces banks to sell their assets to pay investors, thereby reducing asset value and creating financial uncertainty. For example, in the U.S., shadow banking practices largely contributed to the subprime mortgage crisis in 2007-2008 and the recession that followed.
Overall, shadow lending practices signal an increased risk of a banking crisis. While shadow lending may increase the financial sector’s liquidity, they don’t have the same safety nets for debt guarantees or deposit insurance. Yet it’s important to recognize that shadow banking is not inherently risky and plays a key role in the global financial industry. When managed responsibility, some forms of it, such as entrusted loans, have seen impressive growth recently in China.
Protection from Loan Default
Although risk is important for profit, banks must ensure that their money-making practices are held in check and that they are safe from potential failure if their own loans default. Complexity in China’s shadow credit industry is a cause for concern, more so than its size or openness to risk. Banks can help mitigate this risk by understanding how transmissions occur and who will pay in the event of a collapse. It has been recommended to raise capital requirements to limit the ability of financial intermediaries to expand their activities. But overall, it’s essential to address the issue of debt to avoid a financial crisis and consider financial stability for the future.
With shadow lending, there few guarantees and no central body overseeing its activities. While minimal regulation encourages big risks, overly constrictive regulation may suffocate financial sectors that drive the economy. In China, the U.S., and around the world, financial institutions struggle to strike this fine balance.
CEIS assists commercial lenders in identifying and managing risks in order to maintain profitability and preserve standing with regulators. Our experienced and trusted portfolio advisors are able to help commercial and savings bank communities and other commercial lending institutions balance risks and protect themselves against loan default. Contact us to learn more about our loan review programs, loan loss reserve methodology, loan portfolio stress testing, or consulting services.
- Posted by Justin Hill
- On Monday July 17th, 2017
- 0 Comments