China aims to fight growing risks in its financial sector with restrictions on shadow banking assets and interbank lending. But a sudden reduction of liquidity could increase rather than reduce the risk of a financial panic and dampen growth.
Under its new chairman Guo Shuqing, the China Banking Regulatory Commission (CRBC) has rolled out a series of measures to slow down the rapid rise of China’s shadow banking assets. The concern is that these unregulated assets could trigger a financial panic. But a sudden reduction in shadow banking assets could actually cause, rather than prevent, a financial panic and it could also trigger a substantial reduction of growth. Regulators have recently displayed much more caution in implementing new regulations.
Shadow banking assets serve the important functions of rolling forward risky bank assets and allowing banks to lend more. They are loans and other credit assets that banks have removed from their balance sheets and placed into vehicles such as wealth management products (WMPs), structured by investment banking divisions of Chinese banks, or asset management plans (AMPs), structured by brokers. According to recent CBRC disclosures, the total WMP outstanding is over 29 trillion RMB, or around 4 trillion USD. AMPs managed by brokers and their subsidiaries can be as high as 30 trillion RMB, or over 4 trillion USD. Since WMPs and AMPs often invest in each other, the total amount of underlying assets is likely much smaller than the two combined, but it is still likely that they net over 25 trillion RMB. This would be equivalent to 20 percent of all loans outstanding in the banking system.
New credit financed government stimulus
Why did shadow-banking assets grow from nearly zero prior to 2008 to such gargantuan size in less than ten years? In essence, banks created a massive pool of new credit to finance the 2008-2010 stimulus. First, banks financed many projects, which did not generate returns, thus making these loans non-performing. In order to prevent a wave of non-performing loans (NPL), they needed a way to evergreen these loans.
As long as loans sit on banks’ balance sheets, banks have to apply fairly strict criteria to evaluate credit risks and have to meet high capital and provision requirements. The appearance of a large wave of NPL would put a serious crimp on banks’ profitability. In order to delay this risk, banks persuaded high net worth depositors to invest in WMPs, which would then buy the banks’ risky loans. This practice has been a major reason why non-performing loan ratios in China are among the lowest in the world.
Apart from taking risk off the banking sector, being able to get rid of these loans also boosted China’s economic growth. A number of central regulations placed limits on bank lending to infrastructure or real estate projects. If all of the 2008-2010 stimulus loans had stayed on banks’ balance sheets, banks would have had less room to finance new investment. The solution again was to persuade depositors to invest in poorly regulated off-balance-sheet vehicles such as WMPs and AMPs, which could then finance such projects.
Risky assets in lightly regulated vehicles
The downside of off-balancing is that risky assets with questionable cash flows sit in lightly regulated vehicles, often held by individual investors. Banks and brokers have mainly dealt with these risks by finding new investors for products that are coming due, in essence using new money to repay old investors. In the few cases of WMP defaults, the government has stepped in to repay investors to avoid a financial panic. But given such moral hazard, banks had an even higher incentive to off-balance assets, and shadow banking has grown to truly enormous proportions.
Thus, it is understandable that the CBRC rolled out a series of regulations to restrain the risky nature of shadow banking. Document number 5, for example, banned banks from lending to their major shareholders, or from raising money for major shareholders through WMPs. This practice, through which banks’ shareholders financed stock manipulation, was generating volatility in the stock market and may have even facilitated capital flight.
While regulations like the above may be helpful in decreasing market volatility, others threaten to up-end the entire financial system. The CBRC, but also the insurance and securities regulators (CIRC and CSRC) all issued bans on “fund pooling,” a practice in which several WMPs or AMPs jointly invest in loans. Since WMPs typically mature in six-month to one year while the underlying projects require years to complete, banks, brokers, and insurance companies typically use several rounds of WMPs and AMPs to finance projects. Requiring “one-to-one” matching between WMPs and underlying projects is simply unrealistic and may lead to a large number of WMP defaults.
Similarly, CBRC regulation limiting banks’ interbank assets, if implemented too strictly, may lead to a financial panic. Prior to the latest round of regulations, if banks did not have time to raise money to repay investors in existing WMPs, they could pay them off by lending “interbank” funds to the said WMPs. By placing a strict limitation on such loans, the CBRC has heightened the possibility of WMP defaults.
Discourage rather than ban risky behavior
Besides the CBRC, other regulators have realized the problem of harsh regulation and have softened their stance. A PBOC publication, "Financial Times," published an article making clear that the central bank aims for more regulation and "gentle deleveraging." The article also stated that markets should not worry since, “in the process of financial supervision and de-leveraging, "stability" is still the main theme.” The PBOC prefers to discourage, rather than outright ban, certain types of behavior, such as holding interbank assets or borrowing too much on the interbank market. It is clear that the central bank has no wish for sudden stoppage of interbank borrowing.
The CSRC likewise has favored gentler checks against pool funding. The Chinese press reports that injunction against "pool funding" for broker-managed funds is unevenly applied and that in Beijing and Shanghai, the local CSRC office has not even officially announced this prohibition. Even in cities that announced actions against pool funding, brokers are to "self examine" their books, with weeks if not months to report the total size of pools to the CSRC and a time table for unwind.
In a situation with such high levels of both on- and off-balance-sheet credit, much of it impaired, regulators must guard against any action that withdraws liquidity suddenly. The better solution is to nudge banks into slowing the growth of shadow banking activities by raising the costs of such behavior. The Chinese government embarked on a path of high debt in 2009. It will now take patience to correct this Course.