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3 The nature of China’s shadow banking and a comparison with its Western peers

3 The nature of China’s shadow banking and a comparison with its Western peers

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René W.H. van der Linden

threaten the market stability (Schwarcz, 2013). The emergence of shadow

banks is an inevitable result of financial development and innovation. As

a complement to the traditional banking system, shadow banks play an

active role in serving the real economy and enriching investment channels for ordinary citizens. The shift from indirect to more direct finance

will improve efficiency of fund use, and well-conceived and balanced

financial reforms have maximized the benefits of shadow banking while

controlling the risks involved. However, some critics argue that shadow

banking is not properly regulated, and its scale and rapid growth does

raise debt levels and make credit flows less transparent and more risky.

The main risks resulting from shadow banking are liquidity risk due to

maturity mismatch and default risk from loans to weaker companies or

projects. Shadow banking has also contributed to rising corporate indebtedness due to insufficient regulation and poor risk management. Also,

contagion risk increased due to the non-transparent and interconnected

nature of shadow banking, and the moral hazard problem is exacerbated

since the government will always step in to save the borrowers from

default. These arrangements have encouraged crony lending practices

and the concealment of non-performing loans (NPLs). In recent years,

the problems of moral hazard, related-party lending, and loan forbearance have been particularly prevalent in the area of ‘local government

finance vehicles’ (LGFVs), a set of entities set up by the local governments to raise funds primarily for costly infrastructure and real estate

development projects (see Section 5.5). There are a few tools available

to quantify or identify these risks clearly. The problem issue is not the

size but more the rapid growth and increasing complexity of shadow

banking. Profit opportunities for players in the shadow banking activities come from financial repression which distorts the cost of capital and

investment returns, regulatory restrictions on lending and high demand

for loans from many private SMEs. Shadow banking could be considered

as a risk to the financial soundness of the financial system, and investors

are worried that defaults in the banking system could trigger a financial

crisis. Especially from early 2014, there have been several defaults of

trust products (TPs), and the market perception of risk has been heightened since the PBC restricted funding to the interbank lending market

in 2013. However, these concerns are tempered by the authorities’ vast

financial resources and ability to exercise central control (Summers and

Haskins, 2013).

Although the specific content of shadow banking varies from country

to country as financial systems differ accordingly, in Western economies

China’s Shadow Banking System 113

shadow banking generally refers to an investment management scheme,

such as asset-backed commercial paper and structured investment vehicles, that employs excessive leverage to maintain margins by raising

short-term funds and investing them in long-term assets (mostly in

tax havens). In the US shadow banking evolved from formerly government sponsored securitization transactions that were utilized in order

to enhance credit creation capacities for home mortgages. By contrast,

China’s shadow banking is an inevitable result of financial innovation

and has played an active role in broadening the investment channels

for the Chinese private sector, while its Western peers have grown with

the emergence of asset securitization technologies where most shadow

banking activities existed beyond the regulator’s legal jurisdiction.

Compared to the USA, the Chinese shadow banking industry carries less

complex financial instruments and is more domestically oriented. Most

of the financial products are either bonds or belong to the first layer of

loan securitization. For example, loan trusts could be viewed as so-called

privately issued bonds therefore allowing banks to sell or package the

loans into WMPs. By contrast, the USA has a large and more global and

well-developed shadow banking and capital market which includes a

wide range of products that are far more complex in structure than those

in China. The interconnection between the Chinese shadow and regular

banking sector is far greater if compared to the USA, which operates

mainly outside the boundaries of its financial market. Therefore, potential defaults are much less to worry about than in the Chinese system

where defaults have a greater effect on the domestic financial market.

The Chinese shadow banking is similar to the West in the sense that it

serves the function of maturity transformation and has become a tool

to avoid regulations and liquidity crises due to massive withdrawal of

funds as the shadow banking system is not supported by the deposit

insurance system or the discount window of the central bank. Another

similarity between both shadow banking systems relates to the interdependency between shadow and regular banks through the utilization

of off-balance sheet investment vehicles to evade regulatory constraints

and to increase income from lending activities. In both cases regulatory

arbitrage encourages regular banks to increase credit origination capacities through transferring credit risk to third parties.

Table 5.1 shows that China’s shadow banking is very different from

its Western peers. The rapidly growing Chinese shadow banking system

is led by traditional banks through a relatively short and less sophisticated intermediation chain with a relatively low leverage rate and a


René W.H. van der Linden

relatively simple one-layer structure of securitization whereby purchases

are mostly made by individual investors. A lack of a comprehensive

regulatory framework consists of unregulated or poorly regulated family

or local credit businesses and newly regulated non-bank financial institutions that can provide credit. Much of the shadow banking is linked to

property development since China didn’t have a private property market

around ten years ago. A limited credit supply to private companies and

projects as well as interest rate ceilings for bank depositors initially motivated banks to intermediate alternative sources of funds, thereby tapping

into the shadow banking system. China lacks a market for secondary

transfers of credit assets which would allow efficient diversification of

credit and liquidity risks. By contrast, the Western system is termed as

market-based and is mainly led by non-bank financial institutions such

as trust companies and hedge funds, where credit is being transferred

and transformed along a chain of intermediaries. Partly due to a welldeveloped secondary market, the relatively large and under-regulated

Western shadow banking system is characterized by a relatively high

Table 5.1


Comparison between the Chinese and Western shadow banking

China’s shadow banking

Western shadow banking

Domestic financial system

Both domestic and foreign financial


More transparency and more internal

risk management

Under-regulated financial institutions

Lack of transparency and inadequate

internal risk management

Lack of a comprehensive regulatory


Mainly driven by traditional banks

Mainly driven by non-bank financial


Well-developed secondary market

High securitization rate with a

complex structure

High leverage rate

Purchases mainly made by

institutional investors

More mature development phase

Underdeveloped secondary market

Low securitization rate with a simple


Low leverage rate

Purchases mainly made by individual


Immature development phase with

inherent risks

Irregular fund raising and lending

More regular fund raising and


lending operations

Mainly linked to property development Closely associated with the

of local governments and SMEs (mainly property market empowered by

corporate debt concentration) to

modern technology to get around

circumvent regulation

regulatory controls

Source: Authors’ elaboration.

China’s Shadow Banking System


securitization and leverage rate, and purchases are mostly made by institutional investors (Wiegelmann and Petersen, 2013).

As a complement to the traditional banking system, shadow banks

play a useful role in serving the real economy including the real estate

market, either directly or indirectly through financing platforms of

local governments. China’s shadow banking sector is part of the overall

financial system which is characterized by excess liquidity and causes

a rapid debt accumulation by the local governments, a ballooning of

the housing bubble and an industrial overcapacity. If this is allowed to

continue, the financial system will be hard hit when the bubble bursts.

Although shadow banking allows for alternative funding sources, such

loans may be more expensive to pay back, increasing the risk of default.

This explains why the authorities consider shadow banking as one

of the specific problems and challenges facing the Chinese economy

alongside declining demand, overcapacity and local government and

corporate debt, which has to be addressed through ‘reforms, adjustments and innovation’ to deliver continued growth (Summers and

Haskins, 2013).

5.4 The rationale behind the rapid expansion of

China’s shadow banking

As an arm of the State Council, the large SOBs mainly lend to big SOEs

and local governments rather than the SMEs which have long been

the backbone of China’s domestic economy, contributing up to 60 per

cent of GDP and employing around 80 per cent of the workforce. SOBs

consider loans to SMEs and companies that are active in the real estate

and agricultural sector as too risky. As long as SOBs are able to finance

low-risk, high-profit governmental projects, there is no reason for them

to finance higher-risk SMEs. As a consequence, China’s shadow banks

fill this market gap by lending out money to both local government

platforms and private firms. This involves informal securitization that

occurs off-balance sheet through a funding pool provided by banks

whereby non-bank financial institutions lend to mainly SMEs. Savings

are migrating from bank deposits to higher-yielding non-bank credit

instruments, and the SOBs act as important distribution channels for

shadow banking financial products (Buitelaar, 2014).

The main reasons why China’s shadow banking and regulatory

arbitrage have grown so rapidly can be traced back through several

explanatory factors. Several drivers of China’s shadow banking growth

are the filling up of shortcomings of traditional banking, the high


René W.H. van der Linden

margin lending of shadow loans, the additional funding to important

industries which are deprived of proper access to loans, the immature

and volatile capital markets and the excess liquidity that is looking for

an investment channel somewhere. The restrictive regulatory policy

measures in the traditional banking system combined with a strong

demand for credit from the private sector, which unlike the Chinese

households do not have a relatively high savings ratio, have led to more

shadow banking activities filling the gap in the traditional banking

industry. In 2013, the average return of TPs and WMPs to investors

is 7 per cent or higher, while bank deposits range from 2.6 per cent

for three-month to 4.8 per cent for five-year deposits, or government

bonds which yield at 3.5–3.8 per cent, and the Shanghai stock index

recorded a loss of 6.7 per cent (CBRE, 2014). On the deposit side, by

keeping interest rates artificially low, the authorities push savers to

seek higher returns outside the traditional banking system. This results

in demand for WMPs paying rates above the standard deposit rates

which has been further stimulated since measures were introduced

gradually from 2010 to dampen the property market, thus reducing

investors’ interest or ability to invest in real estate. At the same time,

low lending rates create a regulatory need to restrict borrowing to

reduce inflationary pressures or surges of credit into the economy. This

is one of the reasons why investment levels have remained so high in

China over the last decade and at the same time there are many private

companies which wish to borrow, but cannot get access to traditional

bank loans. This is more so at times when the PBC is reducing credit

growth by imposing tighter loan quotas for new loans of the regular

banks (Summers and Haskins, 2013).

From the viewpoint of procuring funds, the real economy started to

face a shortage of funds in mid-2010 as the authorities shifted their policy

from expansion to contraction in 2010–12. Shadow banking became

increasingly important as a source of additional funding to the real

estate industry, the local government platforms and the SMEs. Since the

Chinese banking law limits bank-loan profits to percentages of the loan,

small and medium-sized loans become much less attractive than large

loans. Furthermore, the regular banking sector has strict loan underwriting standards, and SMEs often cannot provide sufficient collateral

to satisfy these standards. Therefore, domestic banks are highly reluctant to lend to small companies and developers, focusing instead on

lending to large SOEs and also investing abroad. Traditionally, SMEs are

perceived to have a high risk profile as there is a lack of a comprehensive

China’s Shadow Banking System 117

credit assessment system and a poor credit underwriting system to identify the better companies or to help set the pricing of loans to SMEs. In

fact, SMEs are more or less forced to look outside the traditional banking

system to alternative financing sources (Schwarcz, 2013).

China’s immature capital markets are still no alternative to traditional

bank loans. The corporate bonds market is subject to interest rate restrictions and primarily comprises of the interbank market and exchangetraded market with a limited size. In addition, the performance of

China’s equity market has been very poor over the past two decades,

which makes it difficult for listed companies to raise capital.

Since China’s money supply far outpaced its real GDP over the last

decade, the excess liquidity floating in the economy is pushing investors to aggressively search for domestic investment products because

capital restrictions prevent a lot of this money from going abroad.

While there are limited investment channels as the capital markets are

rather underdeveloped and volatile and property investment is also

now subject to far stronger restrictions, the excess liquidity is therefore

being pushed to other channels as shadow banking and offshore investments (CBRE, 2014).

From the perspective of investors, shadow banking provides new

investment opportunities as a way to diversify their risks and hence

increase their income. These new products are lucrative to investors since

they provide a higher rate of return than the bank deposit rates. From

the viewpoint of financial institutions that serve as the intermediaries

for funds, shadow banking is a way to circumvent regulations through

financial innovation. The PBC has established interest-rate regulations

and relatively high RRRs, and regulates bank lending through imposing

a conservative loan-to-deposit ratio (around 70 per cent). As market

competition has intensified, banks have come to use shadow banking as

a tool for expanding lending in lieu of traditional channels in order to

avoid regulations (RIETI, 2013).


The size and scope of China’s shadow banking system

In general, the size of China’s shadow banking is difficult to measure

because there is no complete picture of all its activities and what should

be classified or not. Depending on the used data from the concerning

institution, the size and scope of China’s shadow banking vary considerably, but in all cases it has risen sharply compared to the regular banking.

Despite its own government restrictions, China’s shadow banking system,


René W.H. van der Linden











Bank loans








Entrusted loans, trust loans, bank acceptances

& net corporate bond financing




Non-financial enterprises,

equity & other

Figure 5.3 China’s Total Social Financing as percentage of GDP (2002–2014)

Source: The Economist, 2014d, from People’s Bank of China; National Bureau of Statistics.

at about $4.5 trillion, has been growing about 34 per cent annually in

recent years, according to Standard & Poor’s (2014) and Thomson Reuters

(2014). The shadow banks’ growth spurt is partly the result of the credit

crisis, which rattled China. The total shadow banking lending represents

40 to 45 per cent of GDP and is growing faster than regular bank lending.

In order to get a better overview of the size of China’s shadow banking, the

‘social financing’ indicator provides useful available quantitative information which the PBC publishes each month since 2011 (Figure 5.3).

China’s non-bank lending has increased in recent years as part of its Total

Social Financing (TSF), which is a broad measure of credit expansion,

a unique Chinese indicator which reflects the size of the financing of

China’s real economy by its financial system. TSF measures the provision

of funds or the nation’s yearly flow of liquidity corresponding to the total

credit-to-GDP ratio which has soared to more than 200 per cent in 2014.

The available data in 2014 is largely confined to the TSF, which shows

gross new lending and is made up of several parts. It covers financing

sources such as bank loans (around 146 per cent of GDP), entrusted and

trust loans, bank acceptances and net corporate bond financing (around

55 per cent of GDP), and equity and other financing (around 10 per

cent of GDP). Although traditional bank credits still represent the most

important funding source in absolute terms, other forms of financing

more ‘into the shadows’ have become increasingly important in the last

decade, especially after 2009 (The Economist, 2014c).

The problem with China’s shadow banking is that a lot of its fundraising and lending operations are irregular when compared to Western

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