The Shadow Banking Specter


An old adage goes, “Nothing succeeds like success and nothing fails like excess.” This is quite relevant in the context of China – now facing slowing growth as well as the dangers of the systemic credit risks emanating from the unregulated and unbridled growth of its shadow banking sector. Mark Carney, the governor of the Bank of England, says the greatest danger to the world economy is shadow banking in emerging markets.

The international watchdog, Financial Stability Board (FSB) defines shadow banking as the activities and processes of credit intermediation outside the purview of the formal banking system. It is estimated to account for more than 25 percent of the global financial system with assets of $71 trillion, almost the size of world GDP. Strangely, shadow banking operations are growing more rapidly than formal banking operations are. This is especially so in countries like China. China, the epicenter of “covert banking operations,” last year saw growth of more than 40 percent in its shadow banking operations.

Genesis of Shadow Banking

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The emergence of shadow banking in the U.S. was a product of financial deregulation that began in the seventies, and which encouraged a parallel banking system comprising securitized loans, repurchase agreements, and moneymarket mutual funds activity. Financial innovation and technology only exacerbated the situation.

In contrast, shadow banking in China has emerged as an offshoot of an enormous credit crunch and a system of directed lending that denies access to unregulated lenders such as trust companies, brokerage firms, small lenders, and financial guarantors. The raison d’être may differ but the common thread behind the existence of shadow banking, whether in China or any country, is the scope and possibility of regulatory arbitrage, since lower interest rates put a cap on deposit rates.

Huge investment in the infrastructure and manufacturing sector generated a great appetite for commodities such as base metals and crude oil, and in turn an insatiable need for finance. However, banks in China supply credit largely to state owned enterprises at low administered interest rates. This system of directed credit led to a missing market for credit for ventures and projects by local government agencies, small and medium enterprises (SME), and real estate players.Short of funds, they sought recourse from the informal lending route while savings looked for returns higher than the abysmally low bank deposit rates, filling the gap.

Second, in contrast to the U.S. situation, shadow banking in China has a strong interface with the regulated banking industry and that can be problematic. This strong relationship between shadow banking and its formal counterpart exists since banks could sell assets to trust companies. As part of their off-balance sheet activities, commercial banks augment credit by channelizing it via trust companies, investment vehicles, and wealth management products. These banks not only have controlling shares in trust companies but also carry out a credit intermediation process by outsourcing loans to them. These trust companies along with banks issue wealth management products that attract savings desperately searching for higher yields than those the traditional banking can offer.

Regulatory Arbitrage

The U.S. experience shows that shadow banking operations cause problems in the presence of either large maturity mismatches or capital shortages to absorb losses. The most troublesome were those which infected the formal banking system. The danger with China is that regulatory arbitrage is happening at an alarmingly high rate because of excessive restrictions on deposit and lending operations.

Banks in China have been asked not to extend loans to speculative sectors like real estate that are believed to give better returns to investors. Banks have also been obliged to offer higher rates to attract deposits. This intervention in the financial sector, which leads to a suboptimal allocation of funds, is the key to understanding the growth of shadow banking operations in China. It encourages the entry of non-banking players (less regulated than formal banking) to take positions in risky loans for better returns.

The solution to checking shadow banking operations lies in plugging the regulatory arbitrage and allowing the cost of credit to be decided by market forces. China has not been prepared to do this.

Global Implications

William Pesek, the Bloomberg View columnist, has rightly said that a China crash could make the 2008 crisis look like a garden party. China has added more than $12.5 trillion to its broad monetary stock since the 2008 financial crisis, and this has added to the stock of risky private and public sector debt. Many of these debtors are likely to default, potentially wreaking havoc to China’s financial stability.

Should it actually take place, a banking and financial crisis in China would be felt worldwide. China is the world’s second largest economy and the leading trader of merchandise across regions. Just the recent slight fall in Chinese GDP growth has triggered a slowdown in commodities exporters like Brazil.

A serious Chinese economic crisis could deal an immense blow to the real estate and construction sector, given their extensive backward and forward linkages with other industries and sectors both domestic and international, especially in ASEAN, Australia, Korea, Japan and Taiwan. Also hard hit would be prices of globally traded commodities, from coal, copper, and iron ore to oil and gas.

Lessons for India

In India too, the formal and shadow banking are intrinsically interlinked. Compared to China, India has a stronger financial structure, but it is far from perfect. Moreover, there is considerable financial repression in India. Different regulatory purviews can exacerbate risks like “liquidity and leverage” emanating from the shadow banking space. Sophisticated structured financial instruments can add to the systemic risk.

An optimally balanced approach to regulate these entities needs to evolve as over regulation can kill economic growth and innovation, while under regulation can cause a spillover of systemic risks to other sectors of the economy. In this environment, deftness and market intelligence on the part of the regulator, and coordination in the case of multiple regulators, is more important than simply coming up with new regulations and monitoring adherence.

Ritesh Kumar Singh is a Corporate Economist. Sarika Rachuri teaches Economics at ICFAI Business School. Both are based in Mumbai, India. The views are their own.

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