China Power

China To Legalize Shadow Banking?

China’s new orders on shadow banking are an attempt to regulate, not ban, alternate lending sources.

China To Legalize Shadow Banking?
Credit: Wikimedia Commons

The Financial Times reports that China’s government is moving to regulate the shadow banking sector, while at the same time officially legitimizing these alternate sources of funding. FT based its report off of a copy of draft regulations reportedly issued by China’s State Council. According to FT, the document called for increasing regulation, but also acknowledged the important role shadow banking plays in China’s economy. “The emergence of shadow banks is an inevitable result of financial development and innovation. As a complement to the traditional banking system, shadow banks play a positive role in serving the real economy and enriching investment channels for ordinary citizens,” FT quoted the document as saying.

The State Council document also attempts to define “shadow banking,” a term that can refer to illegal, unofficial banks as well as more standardized (but not officially recognized) practices such as the issuing of corporate bonds, trust financing, and off-the-books lending activities by state-run banks. According to Bloomberg, JP Morgan Chase estimated the total value of shadow banking activities was $6 trillion in 2013. Shadow lending typically booms as Chinese banks tighten restrictions on loans, which is exactly what happened this year as the central government sought to tamp down both local debt and industrial overcapacity. Shadow banking allows for alternative funding sources, but such loans may be more expensive to pay back, increasing the risk of default.

This is especially worrisome when it comes to government entities. Data released recently by China’s National Audit Office showed that shadow banks were playing a larger role in government debt, especially in financing China’s local governments. Official bank lending represented only 57 percent of local government’s liabilities as of June 30, 2013, down from 79 percent at the end of 2010 (the last time the data was made available). Given this, it’s not surprising that the government is moving to regulate the shadow banking sector — up until now, it has provided a relatively easy way for local government to bypass restrictions on local debt.

The State Council understands that the shadow banking system is here to stay. However, the system could also potentially threaten reform policies by providing an easy way to circumvent loan restrictions that are designed to ease industrial overcapacity and rein in debt. As a result, the document seeks to add oversight and regulation to the shadow banking sector. The State Council document calls for close monitoring of unofficial lending programs, especially those involving trust companies and wealth management products. Trust companies (and even official banks) sell high-yield investment products to consumers, then often use the proceeds to make loans. Reuters reports that the State Council is calling for trust companies to stop the latter half of their activities, and refrain from participating in “credit-type” business.

The move is also accompanied by the announcement that China’s government will allow local governments to “roll-over” their debt by issuing bonds. Such a move will ease reliance on the shadow banking sector — there is speculation that much shadow lending goes to repay other debts. By providing an officially-sanctioned way for local governments to avoid default, the Chinese government could eliminate one of the most dangerous uses of shadow banking.

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The State Council’s order is not a full solution to the problem, but it does mark an important step. First, it guarantees that shadow banking is here to stay — the government has now gone on record calling this sector both “inevitable” and “positive.” Second, the central government seems serious about taking control over shadow banking by clarifying regulatory responsibilities and instituting a growing number of new regulations. To date, specific regulations have not been released, but the government has demanded regulators to tackle the different aspects of shadowing banking in the future. China Business News [Chinese] hailed the document as a sort of “basic law” for shadow banking, one that “clearly indicates the direction of the next step to strengthen supervision of shadow banking.”

As with most of China’s economic reforms, the trick will be defining and implementing the new policies. Previous regulations targeting shadow banking were often opposed by the very organizations that would be implementing the regulations. Chinese officials told the Wall Street Journal that previous rules restricting shadow banking were delayed by the China Banking Regulatory Commission due to opposition among banks and other financial interest groups.

However, the State Council’s surprisingly positive view of shadow banking as a whole should eliminate the worst fears of companies involved in this sector. It’s clear that that government doesn’t want to eliminate shadow banking — leaders merely want to control the risks before they spiral out of control. It’s a way for China to re-exert control over the financial sector while not closing down an important source of alternate financing. Still, the government has a lot on its plate for 2014, so it’s worth keeping an eye on the situation to make sure shadow banking doesn’t slip through the cracks.