A new working paper from the Bank for International Settlements points to the increasing complexity of China’s shadow banking sector as it undergoes key structural shifts.
The paper entitled Mapping Shadow Banking in China: Structure and Dynamics, by Torsten Ehlers, Steven Kong and Feng Zhu from the BIS Monetary and Economic Department, defines shadow banking in China as “all financial instruments that fulfil functions of credit intermediation typically performed by banks (such as liquidity, maturity and credit risk transformation), but reduce the burden of or bypass regulation.”
The paper seeks to produce a comprehensive account of shadow banking in China via the creation of a series of stylised “maps,” dividing the process of shadow credit provision into the three main stages of the ultimate creditor stage, the intermediate stage and the ultimate borrower stage.
This mapping process reveals pronounced shifts in the relative importance of various operations, and highlights five key characteristics of the Chinese shadow banking sector at present.
Chief amongst them is the dominant role played by commercial banks in shadow banking activity, in particular smaller joint-stock and municipal commercial banks.
“[Banks] are the main linkage between the suppliers and borrowers of funds in both the formal and the shadow banking system,” said the paper, pointing to their vital role in the formation, distribution and holding of key instruments such as wealth management products and trust beneficiary rights.
“They create tight interlinkages between formal and shadow banking activities and entities.
“A significant share of the proceeds from bank-issued WMP’s…are channelled into trust products.”
Chinese banks also participate in shadow banking by facilitating “entrusted loans” between companies in the role of both trustees and middlemen.
The second key feature of China’s shadow banking sector is that it fulfils a number of critical economic functions, in particular the provision of alternative savings instruments that provide higher returns than standard deposits.
Shadow banking also helps to channel funds to more efficient, private companies that would otherwise find it difficult to obtain financing, via means such as trust loans made by trust companies, and entrusted loans between companies with banks playing the role of intermediaries.
“Shadow banking provides credit to private firms which otherwise would be unavailable or too difficult to obtain,” said the paper. “As these firms are typically more productive than their state-owned counterparts…shadow credit is likely to lead to direct economic gains.”
The third key feature of Chinese shadow banking is that is produces tight interlinkages within the financial system, in particular between commercial banks and the Chinese bond market.
“A large share of the proceeds from WMP’s have been invested in the bond market,” said the paper. “WMP’s have effectively provided a channel for retail investors to invest in bonds, as direct access to the interbank bond market is restricted to financial institutions.”
The emergence of new forms of “structured” credit intermediation are also dialling up linkages within the financial system, via the conversion of bank assets into investment receivables.
This process involves banks transferring their exposures to trust companies or their asset or wealth management vehicles, in return for full participation rights in the profits and losses via TBR’s and directed asset management products.
“The reclassification of bank assets into investment receivables is generating even tighter and more complex and opaque linkages between the formal banking sector and shadow banking entities,” said the paper.
Despite these expanding interlinkages, the paper highlights limited complexity as the fourth characteristic of the Chinese shadow banking sector, noting that it involves fewer entities and steps of credit intermediation than in the US.
“Shadow credit intermediation in China is a one-step or two-step intermediation process, as it is effectively based on ‘plain vanilla’ loans or instruments that entail a one-to-one link to the revenues from the underlying debt instruments.”
The fifth key feature of Chinese shadow banking is the crucial role played by “implicit guarantees” during the credit extension process, whether perceived or actual.
“In both China and the United States, the expectation of an eventual government rescue of systemically important financial institutions…provides implicit guarantees to investors and creditors,” said the paper.
“In China..shadow banking activities are driven by banks, and the buyers of WMP’s or other products typically assume that the distributing bank provides compensation in case of a default.”
The paper’s authors point out that while banks are not legally obliged to provide such compensation “the precedents set by past bail-outs and the perceived priority placed by the authorities on maintaining financial market and social stability contribute to perceptions of implicit bank guarantees.”