China's banking industry is highly regulated. Paradoxically, this has led to a dangerous rise in financial assets in the unregulated financial industry that has come to be known as "shadow banking." It's estimated that from 2010-12, shadow banking assets
Shadow banking is high-yield lending outside normal bank channels. It provides credit to borrowers that don’t meet normal bank criteria, and naturally comes with higher interest rates.
The practice is not illegal, and serves a useful function in linking those who need money with those who have it at times when the formal banking industry is unable, or unwilling, to provide the funds.
One of the main sources of shadow banking is China’s trust funds, and their assets under management rose by 46 per cent last year. China’s central bank estimates that more than half of Chinese firms have used non-bank lenders such as trusts and leasing and insurance companies.
The fear is that such lending is not only increasing China’s private debt but is also being used for high-risk projects and purposes that, of course, have a greater risk of failure.
These issues were spotlighted in January when a struggling energy company came close to defaulting on a shadow banking investment product worth $490 million. Fears that investors in the whole shadow banking industry might lose confidence were allayed when a bailout was arranged at the last moment.
Opinion is divided on how much the incident reflects the systemic dangers of shadow banking and how much it reflects the specific problems faced by the company that were unrelated to the source of funding.
The Chinese government has reacted by indicating it will increase its oversight of shadow banking. However, there may not be much the government can do to restrain the industry.
The practice is so widespread that to prevent businesses from getting funds they can’t get from banks would cause real problems.
An initial government response has been a pilot programme for people to register their loans, but this has been slow to gain traction.
Pointing out that it is the Chinese government’s excessive regulation and bureaucratic approach to the formal banking industry that led to the rise of shadow banking, critics say there is no easy fix for the current problems.
Unable to operate on a truly market-driven, commercial basis, bank lending has tended to favour state-owned enterprises and politically-favoured companies and projects, making it hard for
the private sector to access the capital it needs.
How much of a problem shadow banking may pose to China’s financial system and its international counterparts is very difficult to judge. However, I am sure we are going to read a lot more on this topic in the months ahead.
The days when China’s financial challenges could remain domestic issues are certainly long gone.