China emerges from the shadows

Andrew Crooke

An urgent crackdown on China’s shadow banking market highlights a major risk to global financial stability. The most toxic parts may have been tamed, but regulators remain cautious.

The Chinese government tends to get its way. Curbing the vast amounts of debt built up within the country’s sprawling shadow banking system is no exception. Shadow banking assets have accounted for over 80 per cent of China’s GDP over the past few years, with a massive growth in the value of wealth management products (WMPs) and asset management products (AMPs). China’s banks also issued a record RMB 2.9tn ($450bn)in new loans in January.

This spiralling debt in the world’s second-largest economy has prompted Beijing to move aggressively to rein in its shadow banking structures amid the risk of more defaults.

China’s reforms are part of a global push to tame the most toxic parts of shadow banking – borrowing and lending that occurs outside normal banking regulations and so does not have the same safeguards. Excessive lending within this unregulated system was a major contributor to the 2007–2008 global financial crisis, yet shadow banking has continued to grow since then.

As a stated government priority, the past 12–18 months have seen Chinese regulators introduce a series of new measures in a bid to control risk and leverage in the financial system. For example, the country’s banking watchdog, the China Banking Regulatory Commission, has increased scrutiny on shareholder investments in commercial banks, and enhanced risk management and disclosure in relation to entrusted loans – a form of inter-company financing that has become a key component of the shadow banking system.


“The large-scale and opaque interconnections of the Chinese financial system continue to pose stability risks

IMF Global Financial Stability Report, April 2018


New rules are also being introduced so that, when financial institutions launch WMPS and AMPs, China’s central bank, the People’s Bank of China, has a greater responsibility to do more risk assessment.

‘The central bank has seen the amount of risk from shadow banking accumulate within the system to such a large extent that it realises there is an urgent need to regulate and reduce the volume of these types of [products],’ says Stanley Chen, a partner at Fangda in Shanghai. The crackdown appears to be working. Growth in China’s domestic shadow banking certainly slowed in the first half of 2017. A Moody’s report in November found that lending in this space was worth RMB 64.7tn ($10.1tn) at the mid-way stage last year, compared with RMB 64.4tn (£10tn) at the end of 2016.

‘The figures show a big drop in volumes of AMPs issued by the banks,’ says David Liu, a partner at JunHe and Co-Chair of the IBA China Working Group. Liu believes that the reforms are proving effective in large part because the requirements for financial institutions are now a lot more specific.

A similar trend can be seen regarding China’s assets under management – held by fund management firms, securities and futures companies, and privately offered investment funds. By the end of 2017, this was worth a combined RMB 53.6tn ($8.3tn), according to the Asset Management Association of China. Although this represented a 3.49 per cent annual rise, it was substantially lower than the 35.6 per cent growth rate in 2016.

More of the world’s assets in the shadows

The Financial Stability Board (FSB) says that its ‘narrow’ measure of shadow banking activities that could pose a threat to stability grew by 7.6 per cent in 2016 to $45.2tn – or 13 per cent of total financial system assets. The measure is taken across 29 jurisdictions that together represent more than 80 per cent of global GDP.

Notable in these latest figures, contained in its Global Shadow Banking Monitoring Report 2017, are the contributions from China ($7tn, or 15.5 per cent) and Luxembourg ($3.2tn, or 7.2 per cent). These countries were both included in the FSB’s annual monitoring report for the first time.

More broadly, in those jurisdictions where finance companies tend to have relatively high leverage and maturity transformation, the FSB pinpoints them as more susceptible to roll-over risk during market stress.

Although the FSB says non-bank financing offers a valuable alternative to bank financing, and helps support real economic activity, it notes that more reliance on this channel raises risk levels.

The report also says that collective investment vehicles with features that make them susceptible to ‘runs’ (for example, open-ended fixed income funds, credit hedge funds and money market funds), which represent 72 per cent of the narrow measure, grew by 11 per cent in 2016.

The considerable growth of these collective investment vehicles – equal to 13 per cent on average over the past five years – has also been accompanied by a relatively high degree of investment in credit products and some liquidity and maturity transformation.

The FSB says this highlights the importance of implementing its policy recommendations on structural vulnerabilities from asset management activities. It adds that new forms of shadow banking are likely to develop in the future, emphasising the importance of continued monitoring to mitigate the risks and support the shift of these activities into resilient market-based finance.


Nevertheless, the International Monetary Fund (IMF), in its latest half-yearly report on global financial stability issued in April, found that, despite the reforms, shadow banking continues to pose a high risk to China’s financial stability.

‘The large-scale and opaque interconnections of the Chinese financial system continue to pose stability risks,’ the report states. ‘Vulnerabilities remain elevated. The use of leverage and liquidity transformation in risky investment products remains widespread, with risks residing in opaque corners of the financial system.’

The IMF urged China to increase oversight of shadow banking from unregulated lenders, which was exacerbating debt levels, and to exercise tighter control of the investment products sold by the country’s fast-growing insurance sector.

This ongoing caution over shadow banking is echoed by a global assessment from the Financial Stability Board (FSB), which coordinates financial regulation for the G20 economies. Its latest monitoring report, issued in March, concluded that shadow banking assets that pose risks to the international financial system grew 7.6 per cent to $45tn in 2016. However, the FSB says that efforts to tackle those aspects of shadow banking that contributed to the financial crisis are proving successful.

‘Over the past decade, G20 financial reforms have fixed the fault lines that caused the global financial crisis,’ said Mark Carney, FSB Chair and Governor of the Bank of England, last summer. ‘We think that what’s left of that [shadow banking] activity is resilient, market-based finance. Without some changes to regulation it would come back in a different guise,’ he added. ‘We’ve put in place measures that both address the toxic side and keeps the activity that is there, and is very worthwhile.’


“China’s central bank has seen the amount of risk from shadow banking accumulate to such a large extent that there is an urgent need to regulate and reduce these [products]

Stanley Chen
Partner, Fangda


The FSB says that, while market-based finance provides increasingly critical alternatives to bank lending in the financing of economic growth, it’s vital that the sector is made robust and resilient. Its March report is the first time the FSB assessed the role of China’s non-bank financial entities in credit intermediation that may pose financial stability risks from shadow banking, such as maturity/liquidity mismatches and leverage (see box: More of the world’s assets in the shadows).

At the core of the recent Chinese reforms to date, the People’s Bank of China wants to ensure that a lot of the idle money that has gone into the domestic shadow banking sector is directed towards more solid industries and investments going forward.

Central bank rings the changes

One of the most significant moves by the government in Beijing has been setting up a ‘super regulator’ after the 19th Party Congress in October 2017, which sees the insurance and banking regulators merge in order to improve what’s regarded as an ineffective and fragmented regulatory system. The following month, the central bank issued a joint statement with other financial regulators, setting out new guidelines and unifying the rules covering AMPs issued by securities institutions, banks and insurers.

The central bank also wants to reduce the general financing costs, to encourage more companies to use traditional channels where they can get cheaper financing. Most recently, in late-April 2018, the central bank unveiled relatively onerous rules on the asset management sector, including leverage limits and a ban on implicit guarantees. These are part of broader efforts to close loopholes that have allowed regulatory arbitrage and asset price bubbles.

Over the next two years, for example, the central bank is expected to cap the total assets to net assets ratio at 140 per cent for open-end mutual funds, and at 200 per cent for closed-end and private funds.

A further initiative from the central bank, announced in April, is the creation of a ‘data bank’ that will measure all financial activity, from leveraged securities investment to local government borrowing. This is intended to help provide a clearer picture of fund flows in AMPs, systemically important financial institutions and the securities, banking and insurance sectors.

With these initial regulatory efforts appearing to make their mark, the central bank is expected to be less forceful going forward amid signs of a slowdown in shadow banking activity. Moody’s reported that shadow banking assets accounted for 83 per cent of China’s GDP in June 2017, down from a peak of 87 per cent in 2016. Yet, broader challenges arise due to the complex nature of how China’s shadow banking system operates.

Recent market research by the Bank for International Settlements highlights important differences to western markets. For instance, whereas shadow banking in the United States mostly involves private investors who make a judgement call to participate in activities outside regulatory safeguards offered by traditional banking, in China, the state is either the key mediator or even the guarantor of the unregulated activity.

Tied to this, other problems are emerging. A March 2018 report by Reuters, for instance, revealed the Chinese government faces challenges in applying regulations uniformly, given how some domestic financial companies and trusts are trying to sidestep them.

More specifically, some of China’s largest shadow banking groups have been ‘shopping’ for regulators in far-flung regions of the country in an effort to find a path of lower resistance. The application of standards, reporting processes and experience of officials can vary between provinces, which may mean a deal can get approved in one province but might get caught elsewhere.

In addition, the impact on the shadow banking space has been a shift of debt in mainland China towards better-regulated parts of the financial sector.However, one of the biggest overall concerns comes from the possibility of more defaults emerging in the system.

With popular shadow banking investments like the so-called trust products losing their gloss, debt-ridden property developers and local governments that used them as a way to raise funds from local investors are likely to become increasingly nervous. For example, Zhongrong International Trust Co and Zhongjiang International Trust Co are both understood to have delayed payments on trust products. Although repayments were eventually made, confidence has been shaken. More problems along these lines are expected. ‘We are already seeing some default or potential default occurring in [some] AMPs. At the least, market players [should] be prepared for that outcome,’ says Chen.

Liu predicts defaults will emerge over the coming months and years. ‘In the early years of shadow banking, too many products came onto the market,’ he explains. Yet he remains optimistic in general. And, as a result of the regulatory initiatives to date, Liu believes that behaviour is now much more rational in terms of new products being introduced.

Keeping investors hungry

As the reforms have taken shape, China’s government and regulators have become aware that putting a lid on unregulated lending in a sustainable way is easier said than done. What’s also become apparent is the need to keep investors happy by introducing new and comparable options to quench the appetite for yield.

As a way forward, China needs to support innovation of financial instruments to further expand channels for capital replenishment at commercial banks. Non-fixed-term bonds and convertible tier-2 bonds are understood to be on the radar.

While borrowers grapple to fund new avenues for (re)financing, cash-rich individuals are struggling to find a reliable home for their funds where they can get enough of a potential return to stir their interest. As Chen warns: ‘Many wealthy investors who have large amounts of cash to invest do not seem convinced by the yield they can get from many of the financial instruments available to them via traditional channels.’

Andrew Crooke is a freelance journalist based in Hong Kong. He can be contacted at