Book notes: Shadow banking in China, by Andrew Sheng and Ng Chow Soon

Andrew Sheng and Ng Chow Soon, Shadow banking in China: An opportunity for financial reform, Wiley, 2016, 288 pages

Is China at risk of a financial crisis? Many influential voices believe so, including the Bank for International Settlements, which recently warned that one of its indicators of banking risk, the credit-to-GDP gap, had now risen to over three times the level it considers a danger signal. However, the countervailing view is that the risks of a Chinese financial crisis are nonetheless low, as most debt is domestic, rather than foreign, and owed to state-owned banks by state-owned enterprises. Whatever the conventional warning gauges may suggest, these factors reduce the risk of China's credit bubble bursting.

Nevertheless, if the Chinese financial system has an Achilles heel, it is usually thought to be located in the collection of unregulated or lightly regulated financial intermediaries that go by the name of 'shadow banks'. This motley collection of institutions ranges all the way from entities that are banks in all but name to the peer-to-peer lending platforms that have mushroomed in recent years. What they have in common is providing financial intermediation outside the formal – and largely state-owned – banking system. These entities also do not enjoy access to the financial safety nets of lender of last resort and deposit insurance, although they engage in the same maturity transformation and credit intermediation functions as banks. As such, this diverse collection of entities is inherently more fragile than the formal banking system.

Calling these entities shadow banks is potentially misleading, as it invites a direct comparison with the structured investment vehicles and 'conduits' that were at the core of the 2008 financial crisis in the West. While some similarities are undeniable – both western and Chinese shadow banks engage in financial intermediation outside the more regulated system, and without the benefit of official sector backstops – in other respects, their differences are more compelling than their similarities. Western shadow banks are primarily creatures of the capital markets, their function being to transform longer-dated securities into shorter-term, more liquid instruments through mechanisms such as repurchase agreements. In the run-up to the global financial crisis, the maturity transformation in which they engaged provided banks with an alternative funding source to retail deposits and interbank wholesale markets, thereby permitting credit to expand far beyond what would have been usually possible, given the supply of these traditional bank liabilities. Correspondingly, it was the collapse of shadow funding chains – and the resultant contraction in bank liabilities – that caused the wrenching disruption of the supply of credit that was at the heart of the crisis.

Chinese shadow banks differ from this model in practically every respect. Rather than being the product of capital markets, they are predominantly quasi-banks, engaging in basically the same credit intermediation functions as banks. The difference has been that, until recently, the formal banking sector in China was subject to a variety of regulatory restrictions – especially on the rates they could pay on deposits and charge on loans – that shadow banks were able to avoid. In this sense, Chinese shadow banks represented a de facto deregulation of the financial system, one that permitted more market-based pricing of credit, and thereby allowed credit to flow to sectors that were otherwise underserved by the formal banking system. The most dynamic parts of the Chinese economy – notably small and medium-sized enterprises – have been beneficiaries of these changes.

Similarly, rather than providing an alternative source of funding for banks, Chinese shadow banks have provided retail investors with an alternative to bank deposits, offering a more attractive yield to depositors than is available from the formal banking system, where real, inflation-adjusted, returns are often negative. And whereas western shadow banking in the pre-crisis years had grown to 150% or more of the formal banking system, shadow banks in China are still dwarfed in scale by 'the big four' state-owned banks. This suggests that the potential for a wrenching disruption in the supply of credit – similar to that experienced in the West in 2008 – is substantially less, even in the event of China's shadow banking system experiencing a destabilising run.

Valuable study

As Andrew Sheng and Ng Chow Soon claim, therefore, the risks associated with China's shadow banks have been substantially overstated. Although credited as the authors of this valuable study, they are actually editors, with most of the contributions being provided by a team from US-based Boston Consulting Group (BCG). The project itself had its origins in a study that Sheng commissioned when he headed the Fung Global Institute think-tank (now the Asia Global Institute at the University of Hong Kong), with the analysis conducted by a BCG team. The book is essentially an expansion of the initial report prepared by BCG and published by Fung.

The various contributions to the book shine a light into the darker recesses of China's shadow banks, concluding that not only is it possible to obtain a clearer view of activities in the sector than many analysts have supposed, but that its risks remain relatively well contained. For example, they examine the impact on the formal banking sector if potential non-performing loans (NPLs) in the shadow banks migrated to the state-owned banks (for example, if state banks were used to organise a bailout of the shadow banks). They calculate that the large banks' stated NPLs would increase, but that they would remain within manageable limits, on a worst-case scenario rising to around 7.1%.

This study goes a long way towards dispelling the mythology that has grown up around China's shadow banking, and provides an essential corrective to much of the ill-informed comment that has tended to dominate the discussion. And yet there still remains a sense that Sheng and his team may underestimate shadow banking risks in two important respects.

First, although the relative sizes of the shadow and formal sectors are still of a different order of magnitude than prevailed in the pre-crisis western financial system, the growth rate of shadow banking means that the system is now gaining on the formal banks, in terms of asset size. If this pace of growth persists for a few more years, it becomes completely imaginable that shadow banking's share of the total supply of credit will become much more difficult to replace in the event of a systemic shock, and consequently that a bailout by the large state banks would be more difficult to pull off. This unquestionably will increase China's financial system vulnerability.

Second, system vulnerabilities are also increasing because shadow banking's interconnectedness with the formal system is on the rise. In the past, the formal and shadow sectors operated largely in parallel, with potential spillovers limited to the reputational risk to formal banks that used their branch networks to market shadow banking products. However, in the past year, the smaller Chinese banks – most notably the ‘city commercial banks' owned by local governments – have become aggressive purchasers of shadow banking products, funding themselves in the interbank market to do so. The resulting gap between the return offered on shadow banking products and their cost of funds may boost short-term profitability, but only at the expense of rising maturity transformation and liquidity risks.

Sheng and his team might be correct to argue that other analysts have overestimated shadow banking risks, but this should not be taken to imply that their relatively sanguine view will remain correct beyond the immediate future.