PRIMER: shadow banking in China

Author: Karry Lai | Published: 22 Mar 2018
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The term refers to intermediaries that create credit outside the regular banking system and aim to cater to borrowers who can’t get loans from banks. Core shadow banking segments include entrusted loans, trust loans, assets funded wealth management products and undiscounted bankers’ acceptances. Other segments include loans by finance companies, informal lending, financial leasing, microcredit, pawn shop loans, online peer-to-peer lending asset-backed securities and consumer credit companies. Total shadow banking assets stood at RMB65.6 trillion ($8.4 trillion approximately) at the end of 2017, an increase of RMB1.1 trillion compared to 2016.  


Shadow bankingTrust loans are loans made by Chinese trust companies that come with a higher level of credit risk and are often funded by structuring loans into wealth management products with banks acting as distribution channels. Wealth management products backed by trust loans are often sold to retail investors who are attracted to the products as they offer higher yields than bank deposits. However, off-balance sheet wealth management products are not principal protected. Entrusted loans are loans between companies with banks acting as agents to the transaction and are treated as off-balance sheet items. Another item that is treated as an off-balance sheet item to banks are undiscounted bankers’ acceptances which are short-term debt instruments issued by a company with trade credit guaranteed by a bank.


What has been happening at the top?


A number of measures to curb liquidity risks and manage shadow banking have been announced since the beginning of the year and more can be expected. The China Banking Regulatory Commission (CBRC) announced its 2018 priorities after its two-day national work conference in late January. The CBRC’s priorities for 2018 include reducing shadow banking, lowering corporate debt and limiting household leverage. While the overall risk in the banking sector is under control, the CBRC has indicated that the situation remained 'grim and complicated’. The IMF has 'welcomed the significant steps taken by the People’s Bank of China and regulatory agencies to strengthen financial sector supervision against a background of rapid financial sector growth and deepening’.


People’s Bank of China governor Zhou Xiaochuan has emphasised that the Financial Stability and Development Committee will focus on reducing the risk of the shadow banking sector, asset management industry, e-finance activities and illegal operations by financial holding companies. Between March and December 2017, the CBRC investigated over 59,000 cases of illegal or improper behaviour with total assets of nearly RMB17.7 trillion.


What measures are being put in place to curtail shadow banking?


Liquidity risk management


The CBRC introduced three new indicators into a draft revised rule on liquidity risk management which came into effect March 1 2018. These are the net stable funding ratio, high-quality liquid assets adequacy ratio and the liquidity matching ratio. All are required to be no lower than 100% at any time. The net stable funding ratio measures banks’ long-term stable funding to support business development and will apply to lenders with assets of no less than RMB200 billion. The high-quality liquid assets adequacy ratio, which evaluates whether banks have enough high-quality liquid assets to cover short-term liquidity gaps when under stress, will apply to lenders with assets below RMB200 billion. This requirement will be expected to be met by end of 2018. Applying to all lenders, the liquidity matching ratio gauges how well bank assets and liabilities are matched in maturity and will be expected to be met by the end of 2019.


Market participants expect more pressure to be placed on smaller banks.


"The increased capital requirements mean medium and smaller banks will need more recapitalisation," said Nicholas Zhu, vice president, Financial Institutions Group at Moody’s. "Banks are expected to increase capital and if they are not able to, they will need to cut budget growth: there is a need for banks to take care of risk and increase capital."


He added: "There will be more scrutiny on generating new credit and heavier fines from regulators means they are picking up pace on enforcement."


Tighter regulations can be expected to continue to curtail shadow banking.


Credit exposure management


Shadow banking and inter-banking activities are causing Chinese regulators to increase capital requirements by using a look-through approach to look at the structure of a transaction under the current Basel III framework. In January, China drafted a regulation on commercial banks’ large exposure management in line with the Basel Committee on Banking Supervision’s framework. Binding and quantifiable metrics are being introduced to implement the look-through approach when measuring credit exposures of investments in structured products. A bank must aggregate unidentified counterparty risk in a structured investment’s underlying assets as though the credit exposures relate to a single counterparty and reduce that aggregate exposure to below 15% of its tier 1 capital by the end of 2018. The regulation aims to limit opaque bank investment categories such as investment in loans and receivables originating from other financial institutions.

"This would make industries such as real estate and infrastructure which frequently seek financing through non-standard credit assets channel face more financing difficulty"


Targeting asset management companies


Specifically targeting the capital adequacy requirements of asset management companies, draft measures for the capital management of financial asset management companies were released in January.


"The most noteworthy regulation in 2017 is the draft Guiding Opinions on Regulating Asset Management Business of Financial Institutions issued by the People’s Bank of China, the CBRC, the China Securities Regulatory Commission, the China Insurance Regulatory Commission and  the State Administration of Foreign Exchange in November 2017," said Xiaolian Zhang, partner at King & Wood Mallesons. "This regulatory document is a cross-industry guideline for asset management sector and is a milestone for addressing the risk of shadow banking,"

Zhang explains that the draft regulation puts in a number of restrictions, including regulating cash pooling and prohibiting the maturity mismatch of asset management products; prohibiting financial management products to be invested in credit assets of commercial banks; If financial assets are to be invested in non-standard credit assets, the regulatory requirements on quota administration, risk reserve requirements, and liquidity administration, among others, developed by regulatory authorities shall be complied with; and remove multi-layered nesting and channels.


In addition, the CBRC issued the Notice on Further Rectifying the Market Chaos in Banking Industry on January 12 2018. It named several types of non-compliance business in this notice, including: illegally conducted inter-bank business, illegally conducted wealth management business, illegally conducted off-balance-sheet business.


As the supply of credit to borrowers gets restricted, refinancing risks for borrowers that are dependent on shadow banking will rise, including sectors such as property development and businesses dependent on local government financial vehicles.


"Such new regulatory measures will impact significantly on the non-standard credit assets. This would make industries such as real estate and infrastructure which frequently seek financing through non-standard credit assets channel face more financing difficulty," said Zhang. 


Tackling invisible shareholders


To address the problem of invisible shareholders in the banking sector, the CBRC is limiting the number of commercial banks investors can have major holdings in such that a single investor cannot hold five percent, or more of more than two commercial banks or a controlling stake of no more than one lender. Stake purchases over five percent need to be approved by the CBRC and major shareholders of commercial lenders cannot hold interests in the same institution via financial products. In an effort to target invisible shareholders that try to manoeuver their way into control of banks through proxy shareholding, shareholding entities are required to reveal their real identities and purpose for investing in a bank.


Targeting funding sources


On the lending front, the CBRC is also increasing scrutiny over the entrusted loans sector. Under the CBRC’s new rules, commercial banks should not participate in the decision making of entrusted lending or provide guarantees. In terms of funding sources, commercial banks are advised to not participate in entrusted loans that use bank credit and borrowed capital as funding sources. Entrusted loans are also banned from a range of investments, including bonds, futures, asset management and financial derivatives products.


"So far in China, a lot of shadow banking activities are fueled and driven by banks in order to avoid capital requirement and reduce non-performing loans," said Yongmei Cai, partner at Simmons & Simmons.


She explained that wealth management products issued by banks investing in credit assets and entrusted loans are two major forms of such activities. The new asset management business rules have tightened issuing such products by banks and forbid those asset management products from investing in bank credit assets. The new entrusted loans rules forbid banks from providing guarantees for entrusted loans and also forbid the loan proceeds from being invested in capital markets or derivative products.


"The recent increase of shadow banking activities has been also due to rise of small and medium joint-stock commercial banks in China," said Cai. "Shadow banking provides alternatives for avoiding capital requirements and granting credit to small companies which otherwise may not be possible."


These shadow banking activities also provide more linkage between provider and user of funds and make otherwise impossible lending activities due to heavy regulations possible. However, these activities will also need to be regulated to ensure that consumers’ rights and interests are protected.


"The increased regulations can help to address increased concern of using shadow banking to circumvent regulatory control on capital adequacy and manage banks’ regulated activities," added Cai.  "For example, certain wealth management products investing in credit assets gave the false impression that they are guaranteed by banks."


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See also

PRIMER: Chinese NPLs


Greece’s bad bank for bad loans


The NPL clean-up