Shadow banking: risks lurk in the murk

Chinese lenders have been criticized for using a shadow banking system to move sour assets off their balance sheets, thereby creating potential risk for the nation's financial system.

In developed countries, shadow banking usually refers to unregulated non-bank financial entities, such as hedge funds, money market funds and other structured investment vehicles that provide services akin to commercial banking.

In China, the landscape looks a bit different.

Xiao Gang, chairman of the Bank of China, the nation's biggest foreign-exchange bank, said the shadow banking system here includes trust companies, small loan companies, underground lenders and even pawnshops. "But basically it involves a liaison between banks and trust companies and private lending," Xiao told the Davos Forum earlier this year.

He wrote a commentary last month urging action to tackle shadow banking, arguing that short-term investment vehicles, known as wealth management products, pose systematic and regional risks to the financial system.

The bank-trust system involves four parties: the bank, the trust company, investors and borrowers. In branches and online, banks sell wealth management products to investors offering higher returns than traditional bank deposits. The money they collect is entrusted to trust companies to fund property and infrastructure projects that may have problems getting normal bank loans.

By July 2010, the bank-trust system involved more than 2 trillion yuan (US$318.5 billion), causing headaches for national credit controls. The China Banking Regulatory Commission subsequently introduced a series of measures to rein in the system in a bid to prevent the commercial banks from hiding credit risks off their books.

According to the latest report published by China Ping An Trust Co, wealth management products issued by the banks reached 4.6 trillion yuan by the end of last year.

Some analysts praised shadow banking for helping businesses in need of more liquidity.

"Shadow banking, such as the trust loan, plays a critical role in social financing in China," senior Datong Securities analyst Hu Xiaohui wrote on Weibo.com. "Companies and local governments that have financing needs but cannot get bank loans can fulfill those needs through shadow banking."

Bank executive Xiao sees it differently. He said some wealth management products are no more than Ponzi schemes. In some cases, long-term projects are funded by wealth management products with tenures of less than a year, or even as short as weeks.

"If the loans turn sour and the banks have no money to pay back the investors on short notice, a simple way to avoid the problem is through issuing new wealth management products to repay maturing products," said Xiao.

He warned that the current low level of non-performing loans at the nation's lenders might not tell the whole story of the financial condition of borrowers.

"Many industries have excess capacity after years of aggressive expansion, and a lot of money has become involved in property speculation," Xiao said. "Eventually, indebted companies may fall into default or hit severe cash flow problems."

Zhou Xiaochuan, the governor of the People's Bank of China, told the media at the 18th National Congress of the Communist Party of China that risks are currently under control.

"Shadow banking exists in China, just like it exists in many other countries," Zhou said. "But the nature and the scale of it is nothing compared to that of developed countries, where the problems were exposed during the financial crisis."

He went on to say, "Most of non-bank related financial activities are under supervision in China, unlike the situation in some countries, where the activities are completely unregulated. But we should stay alert about potentials risks and undertake effective supervision."

Shang Fulin, chairman of the banking regulatory commission, echoed Zhou's comments.

He said trust wealth management products are within the regulatory scope of his agency. The commission will strengthen its monitoring of shadow banking in a bid to fight any malpractices, he said.

The banking regulator, however, didn't dismiss the significance of the links between banks and trust companies. It's legitimate for trusts to manage assets entrusted to them by banks, Ping An Trust said in a report.