Shadow hangs over banks

China's banks have significant exposure to shadow banking activity, which continues to weigh on the credit quality of the banks, according to a Moody's Investors Service report released Monday.

The rating agency said in the report that shadow banking poses continuing risks to banks, particularly in China, where shadow banking activities involved an estimated value of 29 trillion yuan ($4.7 trillion) by the end of 2012, equivalent to 55 percent of China's GDP.

China's banks are exposed to shadow banking activities through their involvement in off-balance-sheet wealth management products (WMPs), trust loans, and informal lending, which banks sell as high-yield alternatives to bank deposit rates, according to the report.

"The impact of shadow banking on banks is difficult to assess at this point, given the lack of transparency and the fast-evolving nature of shadow banking in China," Hu Bin, a vice-president and senior analyst at Moody's, was quoted as saying in the report.

Moody's estimates the growth rate of core and broad shadow banking activities have exceeded a cumulative 75 and 67 percent over the past two years respectively.

Shadow banking provides borrowers who have limited or no access to regular bank loans with an alternative source of funding.

However, the opacity associated with shadow banking products and the threat of loss and contagion outweigh the potential benefits of diverting riskier borrowers from the formal banking system, Hu said.

As a non-transparent and less-regulated way to expand credit options, shadow banking can stoke asset bubbles and may pose risks to financial stability, Moody's said.

Some large European and US banks have sustained severe losses in recent years from exposure to subprime lenders, structured investment vehicles, sponsored money market funds and other off-balance-sheet conduits, the rating agency said by way of illustration.

In late March, China's banking regulator ordered banks to strengthen checks on the underlying assets of a range of WMPs, which are part of China's shadow banking market, to ward off potential risks to the financial system. The tightened regulation is a credit positive for banks, according to the Moody's report.

China's commercial banks issued a total of 31,673 WMPs totaling 7.6 trillion yuan in 2012, an increase of 68 percent from the prior year, PricewaterhouseCoopers said in a report published on Thursday.

The fast development of WMPs and other shadow banking activities are the result of an unprecedented level of competition in the traditional banking business.

Shadow banking products are also aimed at circumventing regulations on deposit and loan pricing, which remain capped despite recent moves toward interest rate deregulation. For yield-seeking customers, banks package high-yield WMPs that often fund trust loans arranged for riskier borrowers to whom banks are unwilling to lend.