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Shadow Banking in China

How does P2P lending and FinTech give rise to the shadow banking industry in China?

What gave rise to the need for shadow banking in China?

Deng Xiaoping and Richard Nixon met in 1979 in hopes of reforming China's economy. Chinese citizens at the time lived in a closed economy with very little global trade. Unfortunately, having a closed economy meant poverty for hundreds of millions of people, which was largely due to the failed efforts of Mao Zedong's Cultural Revolution. With millions of people in an unsustainable agrarian economy, in which people were misreporting the amount of crops they were growing, famine quickly spread through the country leading to the death of 30 million people.

In 1979, however, this all quickly changed. China began the transformation of its economy and the modernization of its financial sector. Unfortunately, since then, its credit market has suffered from allocation inefficiencies that particularly affect small and medium enterprises (SMEs). Why is this so important?

In a time of slowing economic growth, this misallocation of capital has an important impact in that SMEs represent 80% of the economic output of the country, whilst only receiving 20% of the credit originated by banks. This mismatch has led to the growth of the shadow banking industry in China. Since 2009, China's shadow banking industry has expanded its activities via Peer-to-Peer (P2P) lending channels. In just a few years, FinTech has allowed a trillion-dollar and decade-old industry to emerge at the beginning of the second decade of the 21st century.

What is shadow banking?

The Financial Stability Board (FSB) describes shadow banking as "credit intermediation involving entities and activities outside the regular banking system." In China's case, shadow banking is simply an informal sector performing credit allocation between lenders trying to move liquidity from savings accounts with yields limited by restrictive rate ceilings and non-State firms looking for the much needed capital to finance their growth.

Shadow banks perform similar functions and assume similar risks to banks, namely those associated with maturity, credit, and liquidity transformation. They increase the risks for financial stability though by operating outside the formal banking sector, which means they lack a strong safety net, such as publicly guaranteed deposit insurance or lender of last resort facilities from central banks. They also function with a different, and generally smaller, level of regulatory oversight. This is why there is such a strong focus on shadow banks today.

Let's provide a simple example to better understand how shadow banking occurs. Imagine a developer approaches a bank asking for a loan. Since the developer is unsecured, it is willing to pay a high rate of nine percent. The bank agrees, but it must first raise the funds to proceed. To finance the loan, the bank entices depositors to make large deposits by promising them a return of six percent. Because that exceeds the 3.3 percent maximum allowed by China, the bank sets up a special wealth management product, which it offers via a trust company to keep the transaction off the bank's books. Again, working through the trust company, the bank, now equipped with the money from depositors, arranges the loan to the developer. The developer pays 9 percent interest, plus a hefty fee. The bank pockets the fee and the difference between the 9% it gets from the developer and the 6% it pays to depositors. Both sides of the transaction are kept off the bank's books - but if the developer fails, depositors could lose out on their investment. See the below illustrations for better understanding.

Growth of P2P lending and its direct correlation with shadow banking 

The emergence of financial technology has allowed for this activity to digitize itself in the form of peer-to-peer lending channels. Since 2009, China's shadow banking industry has expanded its activities via P2P lending channels, as seen in how within just a few years, FinTech has allowed a trillion-dollar and decade-old industry to emerge at the beginning of the second decade of the 21st century.

Technology has exponentially increased the ability of private actors to pariticpate in shadow banking and China has seen the rise of over 2,000 P2P lending platforms, compared to only one in 2007. In July 2015, China's P2P lending platforms numbered 2,136, with settlements of around RMB 82.5 billion transactions in that single month. Troubling is the fact that 130 closed in the previous two months alone and over 1,250 are regarded at risk by local credit rating agencies.

The rapidness with which this sector originated has prevented regulators from drafting adequate legislation to ensure consumer and prudential safeguards, while at the same time underpinning development of the market. This mammoth shift challenges not only the viability of traditional banks, but also classic financial market infrastructure and the capacity for the State to maintain a resilient financial system.

How is China handling this issue?

In March 2015, the CRBC announced the enactment of new capital requirements for P2P platforms. The sector went from light-touch regulation with low barriers to entry to one where actors in this market may now need to set aside over 30 million yuan in regulatory capital.

This shift in the approach by regulators is a reflection of the fact that the P2P sector in China has reached a critical size. It went from too-small-to-bother to too-big-too-fail (sound familiar?). However, it performs an important allocation role, especially for SMEs that have limited credit access.

China this year has tightened monetary policy and initiated a regulatory assault on off-balance sheet and interbank lending, squeezing financing for speculative fields in order to crackdown on shadow banking.

The China Banking Regulatory Commission (CBRC) issued a flood of orders including detailed work aimed at "regulatory arbitrage," or rule-dodging. Regulatory arbitrage is a practice whereby firms capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulation. Arbitrage opportunities may be accomplished by a variety of tactics, including restructuring transactions, financial engineering, and geographic relocation. Regulatory arbitrage is difficult to prevent entirely, but its prevalence can be limited by closing the most obvious loopholes and thus increasing the costs associated with circumventing the regulation.

Chen Long at Gavekal Dragonomics detailed in a note to clients, "Basically every commercial bank in China is involved in at least some of the long list of activities now targeted by regulators."

Chinese investors have now come to realize that Mr. Guo was serious in his attack on shadow banking. The result is increased yields on Chinese bonds, while share prices in Shanghai and Shenzen have fallen.

James Mackintosh from the Wall Street Journal states, "the major concern about China is that its credit boom must eventually follow every other in history and turn to bust. But China has demonstrated time and again that it can delay the moment of reckoning, and it might even delay it long enough to grow out of its credit excesses, so long as it can head off further worsening. Slower growth with less new debt would be a good thing, so long as the old debt can be contained."

 

The reason to be concerned about China now is that a slowdown in credit hurts growth and could spread to the rest of the world, piling pressure on commodity producers. The broader impact will hit emerging markets in general, which are more dependent on commodity production than the developed world and are bigger suppliers to China. In all likelihood, China's credit-driven economy will slow, which is not great news for its suppliers.

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