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5 The size and scope of China’s shadow banking system

5 The size and scope of China’s shadow banking system

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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

China’s Shadow Banking System


practices. This will make it difficult to determine the size of shadow

banking, which also depends on whether you use a narrow or broad definition of shadow banking. It matters if only WMPs and TPs are considered as is done by Zhang Ming (2013) or entrusted loans and private

lending are also included as is done by Standard & Poor’s (2013). The

specific scope of China’s shadow banking products is not clear yet, but

a variety of both on- and off-balance sheet transactions can be classified

as shadow banking. On-balance sheet products include corporate bonds,

bank acceptances, equity financing and asset-backed securities, while

off-balance sheet products can be found, ranging from undiscounted

acceptance bills, asset backed bonds, collective TPs and entrusted loans

to banks’ WMPs and LGFVs.

As local governments are prohibited from raising funds on their

own account, they set up platform companies or LGFVs to fund their

projects. These projects generate income which LGFVs use to pay the

interest and principle, but this income is not always sufficient to service

the debt. If the projects fail to produce sufficient income, the LGFVs

will not be able to meet their obligations to banks, which will raise their

NPL ratios. LGFVs have built up huge mismatches between their shortterm borrowing and the long-term investments in infrastructure and

real estate. Since land is considered as an important source of financing

and collateral to LGFVs and determines its creditworthiness, this means

that local governments and banks are increasingly vulnerable to the

real estate volatility and dependent on land sales and rising property

prices. Since shadow banking has become a more important source of

credit and is more risky than regular banks, this raises the local government expenditure and debt levels, causing more risks to the financial

system. Therefore, the central government has given permission to

local governments to issue bonds as a way of rolling over their debt

(Buitelaar, 2014).

The fastest growing and most regulated component of China’s shadow

banking system is the trust market which is bound by the Trust Law

and supervised by the CBRC with a lighter regulation than for regular

banks. The trust sector now accounts for about 20 per cent of GDP and

consists of risky high-yield investment products to consumers which

regular banks cannot undertake due to regulations. The trust market

consists of trust loans structured by trust companies with a short maturity (around 1 to 2 years) with a higher roll-over pressure and entrusted

loans between firms with financial institutions as payment agents. Since

many of these loans are highly leveraged, they pose a systemic risk to


René W.H. van der Linden

China’s economy. TPs can be sold directly to individual investors as

collective investment products subject to a maximum limit of holders.

Alternatively, a trust company can design a trust plan according to a

regular bank’s specifications. The regular bank then raises funds under

its brand, packaged as WMP for investors, and channels the capital to

the counterparty in the form of trust loans off the bank’s balance sheet.

The trust companies provide loans to those with high a high risk profile

including real estate companies, property developers, LGFVs and private

SMEs who have to pay a higher interest rate (8 to 12 per cent) to the trust

company than to the SOB. These were typically the sectors for which

the government wished to cut down credit by traditional banks, and it

implies risks for banks’ balance sheet if the WMPs decline in performance due to a decline in property prices (RIETI, 2013).

Since WMPs are issued and distributed by regular banks, they represent the expansion of their traditional deposit businesses, and the provision of new investment products in line with practice in other markets.

WMPs are more an example of financial innovation rather than regulatory arbitrage. This distinction reflects the debate as to whether the

shadow banking sector should be seen as inherently risky regulatory

arbitrage or an innovative stimulus to financial reforms which also

serve real needs of both investors and businesses (Summers and Haskins,

2013). WMPs are higher yielding deposit or investment products, which

do not specify where funds are used. WMPs are typically short-term with

an average term of less than six months and are sold mostly via banks

and offer investors a return of 1 to 2 per cent points above bank deposits.

Most banks’ WMPs are not stated on their balance sheets, as banks do

not assume the risk on their own, given that the contract documents do

not guarantee the principal and interest rates. WMPs are mostly fixed

income-type products invested in a variety of assets that banks market

to customers as higher-yielding alternatives to traditional deposits. In

principle, banks simply manage WMP assets on the account of the client

instead of the bank, so they are exposed to losses if the assets decline

in value. As a result, two-thirds of the WMPs are issued by banks’ offbalance sheet vehicles and trust companies mainly invested in high-risk

property projects and in smaller private firms. One reason WMPs offer

higher rates is that they are based on riskier bank loans, and this makes

them shadowy because the banks hold these loans off-balance sheet

and do not set aside capital against their potential defaults. Instead, the

banks typically extend them via trust companies that are not allowed to

accept deposits or create money, but are allowed to manage it. The trust

China’s Shadow Banking System 121

companies work together with SOBs to repackage loans as WMPs, which

banks distribute for them in return for a commission. The proceeds are

recycled back to the trust company which then invests the money gathered through a WMP in a given company which deposits the money at a

back or turns around and invests it in a WMP (Guilford, 2014). Legally,

banks will not be liable if a TP defaults, but as banks sell these products

they may nevertheless bail them out to maintain good customer relations (Jacob and Siepmann, 2014). Since more and more trust companies lend out money to projects with an overcapacity, this creates a

great concern that these investments are unlikely to generate returns

in the short term. WMPs have been the major source of funding, and

as WMPs are rolled over at short-term intervals, more and more new

issuances are needed to pay off the expiring ones. A vicious cycle has

developed, sparking growth in shadow banking activities and rendering

these types of investments highly vulnerable to a sudden shortage of

funds (Thomson Reuters, 2014).

In addition to the core shadow banking products, there are also small

lending companies and an informal lending circuit where borrowers pay

interest rates of 20 per cent or more. The legal small lending companies

fall under the supervision of the city government, operate on a smaller

scale and are funded in the short term by money from wealthy individuals. Their focus is on rapid growth rather than risk management,

and the outstanding loans represent 1 per cent of GDP in 2013. The

most elusive and least transparent part of China’s shadow banking is

the informal underground intermediation with an unknown size. It

concerns loans to smaller companies and individuals mainly based on

personalized or informal networks of relationships without any collateral, proper bookkeeping or supervision (Buitelaar, 2014).

5.6 Reasons for and against a potential crisis in

the making

There are concerns that China is on the verge of a new credit crunch,

unless the risks coupled with shadow banking are put under proper

supervisory control. Although different from the US subprime mortgage

crisis in 2007–08, there are also some similar patterns to be observed in

terms of a rising debt burden. China’s credit-to-GDP ratio has been rising

quickly between 2008 and 2014, much like the US’s credit-to-GDP ratio

did prior to the credit crisis. Significant concerns have been raised about

the interconnected relationship between regular and shadow banking

122 René W.H. van der Linden

activities. A particular fear is that risk exposure might be heightened

owing to a lack of transparency on these types of investments. The less

regulated shadow banking system could create a new system-wide financial crisis if the current situation is not closely monitored (Thomson

Reuters, 2014).

On top of liquidity, default and contagion risks and moral hazards

(see Section 5.3), China’s shadow banking is also associated with the

following risks. First, the shadow banking system enforces a credit

boom, which could have a pro-cyclical effect and hence undermine

the financial stability. Second, because of the interconnectedness

between shadow and regular banks, the sources of income and operations of both banking businesses are intertwined, so the risks could

have repercussions on other industries and markets unless an effective

separation wall is constructed. Third, a substantial part of financial

transactions in shadow banking is somehow connected to the property market, so a crisis in the real estate market automatically affects

the banking sector. Fourth, the effectiveness of macro-prudential and

monetary policies may decrease since some shadow banking entities

continue to invest funds in the LGFVs, real estate and industries with

high contagion risks and overcapacity. In addition, these bodies could

induce adverse selection and moral hazard by hiding the problem of

‘bad’ loans. Fifth, shadow banking can adversely affect the management of regular banks. To acquire customers, some shadow banks

promise higher rates of return than bank deposit rates which could

result in funds flowing out of banks, thus causing liquidity problems for the regular banks (Buitelaar, 2014). Finally, informal financial institutions that carry shadow banking functions, such as certain

small loan firms, pawn shops and credit guarantee companies, are

increasing their lending volume by ignoring rules and risks. Due to the

lack of proper oversight from authorities, operating beyond the business lines has become widespread. With these risks in mind, the PBC

is aiming at a more reasonable determination of the scope and level

of supervisory management to combat the problems and potential

risks in the development of shadow banking by building a diversified,

multi-layered financial system that focuses on developing statistics to

determine actual conditions, sharing and disclosing information to

improve transparency and promoting continued financial reforms. In

the near future it will become important to strengthen the supervision of shadow banking and increase the cooperation among supervisory authorities. Therefore, it will be necessary to clearly separate the

China’s Shadow Banking System


operations of regular and shadow banking to segregate their risks and

impose appropriate capital and liquidity requirements on their activities (RIETI, 2013).

Besides several reasons for a crisis in the making, there are also many

counter-arguments to put this into another perspective and not necessarily worry about a new financial crisis. Since most Chinese banks

are state-owned, the government as a lender of last resort will likely

step in to provide support in times of trouble, and the government

has sufficient means to manage a bail-out. Also, the authorities have

already taken actions such as tightening regulations to curb the expansion of shadow banking which could help to avoid a financial crisis.

Although China’s shadow banking is increasing, the size is still rather

small compared to the existing bank lending and shadow banking in

major developed economies which is much greater in scale than in

China. Moreover, the deleveraging of the shadow banking sector has

just begun, and its massive expansion has slowed recently. Because

the leverage ratio is relatively low, market turmoil due to deleveraging

also will likely be avoided. As WMPs are typically short-term, there is

a maturity mismatch with funding gaps often financed by interbank

liquidity. However, due to the interbank funding pressures in June

2013, the WMP business has become much less profitable (Jacob and

Siepmann, 2014). Furthermore, since capital flows in China are still

controlled, the RMB is less prone to become a target of speculation.

Exchange controls may prevent Chinese investors from leaving their

money out of the country. Finally, a run on shadow banks is unlikely

since China has the capacity to absorb lots of NPLs and its debt-to-GDP

ratio is much smaller than most of its Western peers. Also, China’s

central government and the big SOBs are still in financial health and

could intervene to buy up troubled assets, preventing the credit market

from seizing up (The Economist, 2014a). All these factors together have

led to a reversal of shadow banking and make it unlikely to lead to a

systemic crisis.

5.7 Preventive and remedial policy measures to tackle

shadow banking risks

The indecision about how to deal with shadow banking has been one

reason why China’s financial markets have faced several looming defaults

on its trust products in 2014. The PBC has pushed up borrowing costs in

the interbank market as a way to curb the growth of shadow banking.


René W.H. van der Linden

Banks turn to the interbank markets for funds and lend the money to

other institutions. Higher interest rates would raise the cost of capital for

shadow banking and could make borrowers more cautious about taking

on too much debt (Lingling Wei, Davis and Shen Hong, 2014). Since

China’s interbank squeeze in June 2013 reached an all-time high rate of

9.89 per cent, several policy measures have been executed to fine tune

the costs and benefits of shadow banking in order to prevent a sudden

credit crunch. The Chinese policy makers understand that shadow

banking is here to stay, and they have become increasingly cautious and

hope that a new set of guidelines will add oversight and regulation to

the shadow banking and closely monitor unofficial lending programs.

China’s current policy on shadow banking is an attempt to regulate, not

to ban alternative sources of funding, while at the same time officially

legitimizing it. The aim is that this will prevent parties from exploiting

the regulatory loopholes in the current system and, as a consequence,

lower the country’s growing debt levels. However, it could also potentially threaten reform policies by providing an easy way to circumvent

loan restrictions that are designed to ease industrial overcapacity and

rein in debt.

With the aim to rein the shadow banking risks it is important to

make a distinction between long-term preventive and short-term remedial policy measures. Preventive measures are necessary to protect the

Chinese financial system from systemic risks. One important example

of a preventive policy measure is structural reforms with more emphasis

on consumption-driven quality growth. China’s government is well

aware of too much infrastructure spending and too little spending by

consumers, and is trying to rebalance the economy by easing interest

rates, loosening interbank liquidities and adding deposit insurance.

Since China’s 12th five-year plan, the authorities focus more on a

consumption rather than an export-driven growth strategy, and also

the government will have to spend more on private firms rather than

solely on SOEs. Since China is growing on a growth strategy that is

maturing and not sustainable as it increasingly faces problems such

as pollution, intensive energy use and resource depletion, there is

more emphasis on quality rather than quantity growth (Lingling Wei

and Davis, 2013). China’s growth policy to further boost its domestic

consumption requires an adjustment of the existing social security and

health care systems which give households more incentives to save

than consume. The huge amount of excess liquidities finally finds its

way into the shadow banking domain. The key question is how to give

China’s Shadow Banking System


the people the confidence to spend money, so in the long run the solution to the shadow banking must also come through an adjusted social

policy (Jianjun Li and Sara Hsu, 2013).

Preventive policy also implies more focus on supervisory measures

detecting credit risk in the system including a structuring framework

for macro-prudential supervision of shadow banking entities as well

as the implementation of transparency standards. Moreover, implicit

guarantees should be transformed into explicit and correctly priced

credit risk transfers. In order to allow all financial institutions to diversify their credit risks, a secondary market for credit assets and risks is

essential to increase the strength of China’s financial system. In the

long run, China is likely to face significant pressure to loosen controls

over credit markets due to steadily increasing financing needs. Besides

attracting foreign investments in Chinese debt, the government already

began to loosen restrictions on credit supply and interest rate controls

(Wiegelmann and Petersen, 2013). In November 2014, the PBC cut the

interest rates for the first time in more than two years, and the State

Council promised to loosen a rule that limits banks’ loans as a proportion of their deposit base, freeing up more cash for them to lend. The

PBC has also been quick to make short-term cash injections whenever

the money market is not offering enough liquidity (The Economist,

2014c). These measures are likely to increase the diversity amongst

Chinese banks reducing both the necessity to conduct shadowy credit

intermediation and the likelihood of defaults due to similar risk-return


In addition, remedial measures have to be implemented with a match

between the means used and the ultimate aim to reduce shadow banking

risks. The following remedial measures could be used:

a government sponsored bailout,

interest rate liberalization and marketization of the money and

capital market,

reduction of the maturity mismatch and default risk of WMPs and

enhancing its transparency,

implementation of ‘firewalls’ between regular and shadow banking


provision of fundraising platforms to SMEs,

reforms of banking regulations, and

stress tests on banks.


René W.H. van der Linden

A government sponsored bailout of the financial sector as in 2000 could

be implemented, when the government decided to set up four asset

management companies (AMCs) to transfer all NPLs to these companies

with the aim to cover up their debt. This was made possible due to the

fact that the government decided to inject public funds into these companies to be able to transfer the debt to the AMCs at a significantly lower

cost. Another option would be to transfer funds of the central to the local

governments in order to give them some support to repay debt, by selling

and privatizing the assets of the local governments to raise capital for

paying off debt. This in particular has been a recent trend in the Chinese

market, and it is likely that this trend will continue due to recent pressure

on credit. The advantage of a bailout is that it has the potential to reduce

adverse effects of a credit crunch, however, the drawback is that it will not

stimulate the growth potential (Lingling Wei and Davis, 2013).

Interest rate liberalization or marketization is one of the goals of the

12th five-year plan and will certainly create more competition between

the banks. A more market-based interest rate pricing reform, which will

allow interest rates to return to their market level, could reduce the

net interest margin on shadow banking products. Interest rate pricing

that reflects market risk would help investors in the shadow banking

system to monitor their own risk levels. It is essential to push forward

the development of a more market conforming money market and build

a multi-level capital market. This would allow investors more opportunities to receive returns on their money, so that they refrain from

seeking out shadowy investments. The bond market is the best channel

for risk pricing in loan rate marketization, but China’s bond markets

are still relatively small. Since November 2014, the authorities have

implemented an important step on the path towards interest rate liberalization by narrowing the margin between deposit and lending rates;

the PBC is forcing banks to pay savers something that is closer to the

actual market price for cash. The central bank also simplified the benchmark structure, it will, for example, no longer post a five-year rate. This

gives banks more flexibility to go their own way in setting rates (The

Economist, 2014c).

The dubious creditworthiness of the risky projects in which many

WMPs are invested means that defaults are an ever present possibility. A

more adequate quality of the underlying assets could minimize default

risk. In addition, as WMPs are rolled-over at short-term intervals to fund

long-term investments, maturity mismatch is the main underlying risk.

By setting a limit on mismatch ratios or on liquidity requirements for

China’s Shadow Banking System


companies using short-term WMPs, regulators could restrict the use

of short-term WMPs to fund long-term investments. Moreover, most

WMPs give often incomplete information about the risks of the projects

in which they are invested. To enhance the transparency of WMPs, the

government could provide guarantees and require issuers to clearly state

where and how capital is invested, the inherent risks and the expected

returns. The CBRC has instructed banks to put high-risk off-balance

sheet WMPs back on their balance sheets and to maintain adequate

provisions for these products.

The CBRC has tightened up its supervision over trust companies by

imposing a RRR and has stepped up its rules regarding the mutual relations and interconnectedness with regular banks. To prevent financial

problems at trust companies from ‘bad’ banks, these banks are not

allowed to extend their business with trust companies, although there

are still opportunities to circumvent these restrictions. Also, the authorities try to prevent regular banks from being infected by shadow banks by

enforcing strict separation between the two, partly through the implementation of ‘firewalls’ which also tries to separate the on- and off-balance sheet activities from each other (Buitelaar, 2014).

The limited access to fund-raising has forced SMEs in China to borrow

through the shadow banking system. In order to minimize shadows

banking activities, more funding should be provided, especially for

SMEs. For example, the government could introduce new investment

tools by easing restrictions on SMEs’ issuance of preferred stocks, and

the PBC is currently focused on ‘targeted’ easing via instruments such as

targeted RRR cuts and re-lending operations for banks engaged in SMEs

and agriculture lending. However, SOBs are generally not keen to lend

to either agriculture or SMEs, and do not have much experience doing

either (CEIC, 2014b).

Strict banking regulations introduced by the CBRC have led to a

reduction of risks inherent in regular operations, but these risks have

merely shifted into shadow banking activities, which are harder to

control. Regulators have to reform the restrictions for loans so as to

shift risks back to the traditional regulated platforms, rendering this risk

transparent to both investors and regulators. Moreover, it is desirable

that more direct measures to regulate off-balance sheet activities will be


Although China has applied stress tests on banks to analyse the

financial performance criteria of its banks, these tests have rarely

published the results in the public domain. It is unlikely that stress


René W.H. van der Linden

tests of SOBs would contain any surprises since they lend mainly to

SOEs and regardless of balance sheets, help to secure social stability.

Stress tests of the largely unregulated shadow banks require sufficient

awareness of the concerning risks, and those conducted by local banks

are not always standardized or aligned with international requirements

and are only reviewed occasionally and unsystematically. Stress tests

could ensure not only that all the banks have to play by the same rules

but also that the banks’ respective services are completely transparent.

In order to raise awareness about a prudent banking system, standardized stress tests on financial institutions’ systems are required, with all

banks following the same scenarios and results disclosed to the public

(Thomson Reuters, 2014).


Concluding remarks and recommendations

China’s economic growth has become increasingly dependent on debt

creation, and the government recognizes that relatively slow growth

combined with a heavy reliance on credit is unsustainable in the future

and might lead to a credit crunch. The adverse effects of this development are noticeable throughout China in the form of ‘ghost towns’ and

vacant apartments, while at the same time there is a considerable overcapacity in the production of building materials such as steel, cement

and solar cells.

Since debt appears to be rising faster than nominal GDP, ‘bad debts’

will inevitably rise among private companies, SOEs and local governments. The default rate, while still small over all, is rising, and in

2014 China experienced several corporate credit defaults. Since the

credit crisis of 2007–08, a declining export growth has pushed forward

debt-financed investments, causing an explosive growth both in local

government debt and in domestic corporate debt, which as a share

of the nation’s GDP is one of the highest in the world. At the same

time, shadow banking as a new phenomenon in China has expanded

rapidly in recent years. China’s shadow banking is a reaction to the

financial repression caused by regulated deposit and lending rates and

has highlighted the risks arising from the opaqueness of its financial

sector, and the rapid growth represents a liberalization of its financial system. Altogether, the bank credit stimulus and shadow banking

boom have left China’s debt at a little over 200 percent of GDP, higher

than most developing countries but well below the major advanced


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