Shadow Banking in China
ShadowBanking in China
Inthe financial and monetary system of China, the banking system playsan exceedingly significant role in ensuring that financial exchangesare successful. One area of banking that is well recognized in theChinese market is the shadow banking. In China, shadow banking is animportant system and has become integrated into Chinese finance.According to the Financial Stability Board (FSB), shadow banking is acredit intermediary that includes organizations and activities thatare perceived to fall outside the normal banking system (Elliott,Kroeber and Qiao 4). In China, shadow banking is viewed as a creditintermediation that provides liquidity and credit transformationhowever, it operates outside the usual banking system. The purpose ofthis report is to discuss the different forms of shadow bankingactivities that are in China, their effects on the financial systemdevelopment, the potential risks of the shadow banking system, aswell as the challenges faced by the Chinese authorities in theregulation of the sector, and the recommendations on how to mitigatethe challenges posed by the sector without necessarily hurting theupside of the system.
TheMain Forms of Shadow Banking Activities in China
Inthe Chinese market, guarantee organizations have their processes inshadow banking in two ways. First, they are involved in the centralbusiness of providing financial guarantees through transferringcredit risk to the guarantee firm. This has the merit of reducingcapital needs for banks that make such assured loans. Also, theguarantee organizations provide direct loans even if they do not holdlegal certificates to engage in the activity (Elliott, Kroeber andQiao 1).
Bankers’acceptances are permits that are issued by banks and provide anagreement to make payment in the future unconditionally, which isusually within a period of 6 months. The BAs are usually backedpartially by a deposit that the party desiring issuance of bankers’acceptance makes (Elliott et al. 7). In this case, the deposit actsas collateral.
TrustLoans and Leases
Trustloans and leases are financial dealings that are assumed by trustcompanies. A trust company is a firm that is independently regulatedand combines aspects of banks, as well as resource managers, inWestern monetary systems. These companies have broad latitude inoperating across the fiscal sector however, strategies areincreasingly tightening restrictions on their activities.
Leasingservice is another activity supported by shadow banking. Financialleasing concerns leasing of different forms of services, which arenot found in banks. The financial leasing is not provided for a shortduration, and some of it may be offered by specialty leasingcompanies (Elliott et al. 1).
Microfinancecompanies are considered to be entities that are independentlyregulated and deal with the provision of financial services. However,the companies have permits to offer credit in small volumes, whichassist in encouraging small businesses and rural borrowers to accesscredit. Therefore, it can be argued that the microfinanceorganizations act as targets for small businesses and ruralhouseholds.
Wealthmanagement products entail commodities that provide a yield on theground of the performance of several basic assets. Essentially, theoriginal investment is a single huge loan. Wealth management productsare offered by banks or trust organizations however, securitycompanies provide similar products (Elliott et al. 2).
Entrustedloans are forms of credits made by companies in the non-fiscaleconomy, which are operated via banks for legitimate purposeshowever, the banks are covered from the loan risk of the debtorthrough the non-fiscal entity.
Sometimes,the commercial bond market is incorporated in obtaining shadowbanking volumes, although the normal definitions in the globe do notsupport the inclusion of bonds in the calculations.
PawnShops and Unofficial Lenders
Theseshops are considered crucial creditors to some family units as wellas meager businesses. Besides, there are other creditors that tend torun informally to friends, relatives, or close associations. Despitesome informal lending being termed illegal, they cannot be believedto have a high percentage in shadow banking.
Impactsof Shadow Banking on the Development of Financial System
Theshadow banks have been associated with positive and adverse impactsin the financial system development. However, despite shadow bankinghaving both negative and positive effects, it can be indicated thatthe positive impacts tend to overshadow the adverse impacts. In thisregard, there is need for the Chinese administration to come up withregulations that would assist in the elimination of negative effectsof shadow banking, which would be critical in ensuring that there isefficiency in the shadow banking system. The positive and negativeimpacts of shadow banking are discussed in the paragraphs thatfollow.
Oneof the positive impacts associated with shadow banking is that it hasthe capacity to fuel economic growth through ensuring that thefinancial services are less costly, as well as being broadlyaccessible to the masses. Compared to the usual banking system,shadow banking system is deemed to have lower operating outlay. Thelow operating costs are perceived as important since they help shadowbanks to offer loans and other financial services to the public at areduced price. Through facilitating cheaper loan and other financialservices to the people, the system is able to reach a vast number ofindividuals a move that can aid in the stimulation of finance schemein the country (Sekine 102). Also, through shadow banking, it ispossible to offer services that normal banks are not in a position toprovide. This is a vital consideration as it provides a criticalingredient towards financial development because the services thatcustomers receive from the shadow banks would play a crucial role inthe development of the financial system.
Shadowbanking has been appreciated for playing a crucial role in the growthof the financial sector since it is deemed to offer more resources tothe SMEs. Originating from its flexibility, shadow banking system hasthe ability to provide services to small and medium enterprises invast numbers. A large number of the SMEs are not capable of obtainingloans and other financial services from the usual banking systemsbecause of the strict regulations that guide the functioning of thebanks in the provision of services. The SMEs usually contributesimmensely to the China’s economy through boosting the economy,increasing the level of employment, promoting innovation, andexpanding exports. The contribution of SMEs to the Chinese economy interms of exports is enormous. Through these contributions made bythe SMEs with the assistance of shadow banks, it can be indicatedthat shadow banks offer a favorable financial setting, which isimportant in the expansion of the financial system.
Thepositive impact of shadow banking is seen in its ability to allowborrowers to obtain resources from a wide range of investments thathave a broader poor of risk preferences. The capacity of convertingcash flows from fairly illiquid resources like long term personalcredits into liquid, diversified, tradable securities that benefitinvestors concerned with investing in securities, which deliver areturn and may be transformed into cash in a simple manner. Theability of shadow banks to modify securities permits the developmentof risk-return compromises that are appealing to all savers. Demanddeposit commodities obtainable through the usual banking systemconventionally have never presented the scope of risk-returngroupings availed to the market-mediated credit. However, through theassistance of the shadow banking system, it has been feasible to fuellarge amounts of available credit to the market. The credit build-upto the borrowers is a crucial element in the development of financialsystem.
Furthermore,another positive influence on the growth of the financial system isthat shadow banking brings avenues for profits from specialty by loanproviders, including superior knowledge emanating from specialism ina distinct zone of the market, as well as economies of scale,realized by emphasizing on certain credit arbitrage roles. Companiesoperating in the non-bank sector and credit guarantors may specializein niche regions, which are not well-served by normal banks. In sucha circumstance, the underserved region by the banks would be capableof generating incomes through the services of the shadow banks, whichwould assist in the development of the financial system.
Despiteshadow banking having a positive impact on the development offinancial system, it also has adverse impacts on the financial systemdevelopment. One of the negative effects on the growth of thefinancial system is that it provides loan services to riskiercustomers or in riskier forms (Elliott, Kroeber and Qiao 4). Forexample, it is in a position to give out loans without collaterals.Through providing unsecured loans to individuals, shadow banks placethemselves at a higher probability of losing resources. The loss ofresources borrowed from the shadow banks is deemed a financial lossbecause the resources could have been invested in another field thatcould have led to financial gains. Therefore, rather than expandingthe financial system, shadow banking may lead to the deterioration ofthe system.
Besides,shadow banking has been perceived to increase financial fragility.Despite the system being believed to lead to securitization as wellas enhancing financial stability through better allocation of creditrisk across varied investors, shadow banking increases financialfragility originating from the off-balance-sheet associations. It ishard to trace the balance sheet of a shadow banking system. Theinvisibility of the occurrences of the shadow banking activities isquestionable to the development of the financial system. According toLiang (14), China’s overall debt increased to 142 trillion Yuan(245% of GDP) in the first quarter of 2014 from about 150% in 2008.Shadow banking led to great credit expansion. The following tabledepicts credit growth in 2011 and 2012.
Source:ShadowBanking in China: Implications for Financial Stability and EconomicRebalancing.
Moreover,because of the attractiveness of the shadow banking system in itsservices for instance, providing loan and other services at a lowprice, most customers may opt running from the regular bankingsystems in order to obtain the services of the shadow banks. In sucha scenario, the normal banks would have a reduced number ofcustomers, which would have an impact on the contribution of usualbanks in the growth of the economy. Such cases have led to thelimitation of the growth of the financial system.
PotentialRisks of the Shadow Banking System
Thereare different potential risks that are associated with shadowbanking. One of the key risks posed by shadow banking system emanatesfrom maturity disparities between funding sources, especially WMPs,as well as risky loans, which end up in risky sectors such as povertydevelopment and coal mining (Bottelier 6). Once trust companies runinto solemn cash-flow problems, the evasions they make on WMPs areaching however, they are not shattering. Predictable contagion tothe Chinese financial scheme is usually limited. Nevertheless, thebet would be wrong in the event of there being a shadow bankingcrisis in China. Besides, shadow banking system has been perceived toreduce the effectiveness of macro-prudential controls and financialsupervision. Some of the institutions linked to shadow banking investin property organizations, high-pollution industries having excessproduction capacity, which interfere with macro-prudential controlsand affect the rate of economic adjustment. This poses a risk to theeconomy since there is likelihood that there would be less concern inthe control of issues that can negatively impact the performance ofan economy.
Anotherpotential risk posed by the shadow banking system is that offinancial instability. Because shadow banks tend to deal with riskyactivities and unsecured borrowers, there is a possibility of defaultamong the customers of the shadow banks. For instance, the localgovernments may default. Most local regimes are usuallyover-influenced and much of their debt is under the ownership offront companies, through shadow banks (Bottelier 6). In reducing theperil of local government evasions, the central administration haslaunched a policy that permits local regimes to issue bonds for thesubstitution of debt. In case the bonds are to be obtained from theshadow bank system, there is a likelihood of a financial instability.
Besides,another potential danger that may emerge originating from shadowbanking is the deceleration of the economy. Due to the cheaper ratesprovided by the shadow banks, for its services, there is apossibility of having huge amounts of resources being given out bythe shadow banking system (Sekine 103). However, because theguarantee for returning the loans obtained by individuals and firmsis very low, most of the resources do not benefit the economy becausethey are geared towards unproductive activities or projects.Channeling of resources to unproductive products can lead to thedeceleration of the economy.
Therealso exists a risk to the normal banking institutions. Shadow bankinghas been considered to have grave implications for normal financialinstitutions, which impact them tremendously. Certain gains fromshadow banking are deemed to be irrationally high a move thatprovides a false incentive for customers, unleash unjustifiableaggression, as well as threaten to steal business from the normalfinancial institutions. These implications tend to influence regularbanking institutions negatively, which may create an environment thatis unfriendly and redundant, despite the institutions operating inthe same industry. Such a move may result in customer sufferingbecause they may not receive what they desire.
Furthermore,shadow banking tends to pose an immense risk, not only to thefinancial field, but also in other sectors. Some of the shadowbanking entities are not regulated in the right manner, a move thathas made them develop recklessly having little emphasis on riskmanagement. Ignoring the control of risks can be seen as a greatdanger because it disregards the safety and well-being of clients(Sekine 103). Besides, the government bodies do not supervise thedaily activities of these organizations, which may present anexcellent ground for problems in the area of business, as well asfields, in which customers operate.
Actionsthe Chinese Authorities Have Taken To Address These Issues
Giventhe expansion of the shadow banking, the authorities started to worrydue to its impacts. There were two great concerns on the side of theregulators: first, they were worried that an uncontrolled shadowbanking sector could generate extreme credit progress and second, alack of openness in the utilization and source of resources couldgenerate concealed perils. Therefore, the authorities focused onthree actions decelerating the speed of non-bank credit expansion,applying discipline on the utilization of the inter-bank market forfinancing, and necessitating the arrangement of shadow assets, aswell as liabilities, to be made open. The following paragraphsdiscuss these actions.
Deceleratingthe Speed of Non-Bank Credit Growth
Throughthis government intervention, virtually all the credit for expansionin 2012 and part of 2013 was from sources other than bank lending.The monetary tightening became applied by the government in 2013 camealmost to a time that there was a deceleration in the pace ofnon-bank lending that brought growth in entire credit down to below15%, while there was virtually no change in the speed of banklending.
ApplyingDiscipline on the Utilization of the Inter-Bank Market for Funding
Disciplineon the inter-bank market commenced in June of 2013, when the PBOCcame up with a liquidity squeeze, which temporarily drove overnightinterest rates to approximately 30%. The panic that resulted infinancial markets coerced the PBOC to backpedal temporarily, but overthe rest part of the year, inter-bank and other short-term fundingrates rose gradually. One of the primary reasons for this action wasto curb the enthusiasm of smaller banks, which had been borrowinglarge amounts on the inter-bank market, so as to fund higher risklending activities that were routed through shadow banking. The PBOCdid not sufficiently communicate its objectives, and markets weretemporarily unsettled as a result however, the regulatory intentionwas sensible and straightforward.
Transparencyof Composition of Shadow Assets and Liabilities
Thedetermination of making shadow banking activities more transparentare incorporated in different regulatory documents such as the StateCouncil’s Document N0. 107 and No. 127 and CBRC’s Document No.140. According to Document 107, the action of fund pools is banned,where trust entities and other WMP issuers cannot move resourcesextensively from one venture to another. Also, institutions arerequired to have a limit on their experiences to individualcounterparties, as well as meet capital necessities for off-balancesheet transactions that did not require to be backed by capital.
ChallengesFacing the Chinese Authorities in Regulating Shadow Banking Sector
Thereare different challenges facing the Chinese authorities as they tryto regulate the shadow banking sector. One of the challenges is thehigh capacity of implicit guarantees throughout the system. It isdifficult to entirely eliminate implicit guarantees because they tendto arise whenever there is the belief that another party can step into bail out an institution or transaction even when the allegedguarantor has made no such promise. Nevertheless, implicit guaranteestend to fade away the moment there are plausible and explicitguarantees or other mechanisms which define what would happen in casethere emerged trouble. Unwinding implicit guarantees is exceedinglydifficult, especially in the country. It is not adequate to simplyindicate that the guarantees no longer exist because the investorshave to see a likely mechanism by which the presumed guarantee canfail to operate.
Apartfrom implicit guarantees, there exists the query of the lender of thelast resort, which is a function of the central bank. Vividly, thePBOC would offer emergency funding to a solvent bank that faces aliquidity crisis. Nevertheless, the PBOC would step in when a vasttrust company or other form of shadow bank has the same problem. Thesolution to this vital question is not clear, and may result invarious issues. The worst case would be if a trust entity or itsfunders presume that the PBOV would get involved and then the fundersencounter losses when the assumption turns out not to be true. Thiscan result in a crisis.
Anotherchallenge entails failure of having an entirely integrated regulatoryframework. Financial institutions are usually involved in a broadrange of businesses directly, through subsidiaries, or throughcooperating with independent organizations such as shadow banks.However, the regulatory system of China comprises of PBOC, CSRC,CBRC, CIRC, and other agencies. This generates regulatory gaps, aswell as loopholes, which financial institutions can arbitrage infinding the kindest treatment.
Besides,a lack of transparency is also an issue when it comes to theregulation of shadow banking system. Since most of shadow banking isa type of regulatory arbitrage, there is an aspect of opacity or evenmisdirection in transactions made. The opacity of the shadow bankingsystem makes the regulations from authorities more likely to fail ordifficult. To make it worse, in a crisis, it can result in panickingsince perceptions of the actual strength of a bank or other financialagency can fall sharply because investors and depositors recognizethat they do not understand what the balance sheet groupingrepresent.
Moreover,in the regulation of shadow banking, another challenge that isencountered is regulatory inconsistency. There are varied,inconsistent reports about regulators permitting or turning a blindeye to actions that are not authorized, openly not allowed, or evenillegitimate. Part of this is arguably benevolent in that it is akind of the classic Chinese technique of the reform era of takingsmall steps and learning about them as one proceeds.
Proposalsto Reduce the Downside without Hurting the Upside of Shadow Banking
Thereare various proposals that can be put forward in reducing thedownside of shadow banking while maintaining the upside of thesystem. One of the proposals is that the banking system needs toexpand the financial services to SMEs, households, and ruralbusinesses. The SMEs have a difficult time obtaining resources fromthe regular banking systems, which is the same case to ruralbusinesses and households (Zhang, Janet and Glenn 86). However, theshadow banking system is in a position to offer loans to these unitswith ease a move that generates a high demand for resources fromshadow banking system. This has the risk of causing thedestabilization of the economy, despite the potential benefits itholds to the economy. In an attempt to correct and regulate thedownside that can be brought by having shadow banking providing a lotof resources to the SMEs, households and rural businesses, it isrecommended that the regular banking system should increase theamounts it channels to these units. Such a move would help inreducing the high demand for resources from shadow banking system,which would create stabilization in the economy.
Anothercritical proposal that can be considered in an attempt to correct thedownside of the shadow banking system while preserving its upside isincreasing the efficiency of the financial sector. Reforming of theshadow baking system must encourage firms to become better providersof services to their target market compared to the regular banksthis would spur regular banks to enhance their businesses. In thiscase, efficiency entails offering services that are tailored to theneeds of customers, at a favorable price, and when needed. Thus,enhancing the efficiency of the system would mean a lot to resolvingthe issues associated with the shadow banking system.
Besides,striving for a level playing ground across the financial sector canbe proposed as another way of ensuring that the downside of shadowbanking system. An important way of achieving a more efficient, aswell as safer financial system, which includes shadow banks entailsstriving to ensure that varied financial sub-sectors contend on alevel playing ground. In short, China needs not influence thesub-sectors that win or lose the market share through implicitsubsidies or generating regulations that create advantage on onesub-unit at the expense of others. If it is one regulation that theauthorities desire to provide for the benefit of the sector, then theregulation should be for all the firms in the sector. Thus, throughhelping shadow banks play a level field just like the normal bankswould help the system in eliminating inefficiencies that itpossesses. Currently, regular banks and shadow banks function underexceedingly different guidelines that offer them unique combinationsof benefits, as well as costs. These guidelines tend to create acrisis in the financial sector.
Furthermore,increasing consumer opportunity, as well as safety, would be animportant proposal for the proper functioning of the system. One ofthe initial shadow banking commodities to emerge in China was thewealth management products, which has been capable of servinghigher-yielding substitutes for bank deposits, at the same time,being viewed as being essentially safe like deposits (Zhang, Janetand Glenn 116). Therefore, this part of shadow banking offers aninstant consumer benefit. In the shadow banking system, part of thelending has gone to small businesses and households, offering themresources that they could otherwise not obtain. The charges have beenhigher compared to those for corporate borrowing however, the ratesare still attractive to individuals without other noble alternatives.The shadow banking should not consider increasing their rates, butshould focus on expanding the benefits further to more customers.Besides, reforms need to emphasize on improving the safety ofconsumers, especially by ensuring that buyers understand the productsand services they are purchasing and the risks associated with them,if any.
Inaddition, it is important to consider defining clearly the nature ofthe safety net for the firms in the financial system. One of thechallenges that make the shadow banks not function properly is thehigh volume of implicit guarantees present in the financial system.Although the implicit guarantees are difficult to deal with, there isa need for developing a safety net within the financial system. Theauthorities should make a clarity concerning which institutions areeligible for lender of last resort aid and the guidelines for theassistance should be spelt out, especially the collateralnecessities. Furthermore, the authorities need to stress on thenecessity of having clarity in the financial associations, especiallythe guarantees, amid financial institutions. This must be confirmed,backed by law and guidelines, or investors should be convinced thatit is not the case.
InChina, shadow banking is an important system and has becomeintegrated into Chinese finance. According to the Financial StabilityBoard (FSB), shadow banking is a credit intermediary that includesorganizations and activities that are perceived to fall outside thenormal banking system. The shadow banks have been associated withpositive and adverse impacts in the financial system development.However, despite shadow banking having both negative and positiveeffects, it can be indicated that the positive impacts tend toovershadow the adverse impacts. However, in order to attainefficiencies in the system, there is need for China to regulate theshadow banking system.
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Sekine,Eiichi. Reforming China’s Financial Markets: the Problems of ShadowBanking and Non-performing Loans. PolicyResearch Institute, Ministry of Finance, Japan, Public Policy Review,Vol.11, No.1.,2015. Print.
ZhangJoe, Janet Cheng, and Glenn Griffith. InsideChina`s Shadow Banking: The Next Subprime Crisis?Singapore:Enrich Professional Publishing, 2014. Print.
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