Understanding China’s Shadow Banking System

China’s shadow banking system, or the informal financing market that lies outside regulator control, has recently come under scrutiny as the Chinese economy slows down to its lowest growth rate since 1999.

If economic growth continues to slow, sudden defaults on loans made in the country’s shadow banking system could threaten China’s banking sector and eventually the rest of the economy.

The unregulated and decentralized interconnected underground economy that comprise the shadow banking system have proven difficult for foreign analysts and observers to pin down. The sheer size of the system indicates that it is interconnected with China’s economy. Shadow banks issue an estimated 14.5 trillion renminbi in loans, roughly 25% of all the loans made in China by the traditional banking institutions.

The shadow banking system is largely composed of investment trusts, pawn shops, guarantors, underground banks, and wealth management products. Investment trusts are companies that manage investors’ money and use it to finance business projects or property loans. In 2011, the investment trust industry was handling 4.8 million renminbi. The total lack of transparency in the investment trust industry–only 10 of the 62 investment trusts in China disclose investment returns–makes it harder to gauge if the highly leverage trusts are facing systemic collapse.

Pawnshops

Pawnshops are prevalent in China, with over 4,000 operating across the country. Pawnshops have become a problem because they accept any sort of collateral for their short-term loans including financial securities like stocks and bonds and even real estate property. If China’s property market deteriorates, pawnshops will be left with defaulted loans that are backed by collateral that have less value on the market.

Guarantors

Like their name suggests, guarantors provide guarantees on loans made to risky borrowers. Guarantors do not makes as much interest as pawnshops and may turn to illegal practices to increase their returns. Guarantors may take a portion of the loan they are guaranteeing and loan it back to the shadow banking system. This enlarges the potential for investors to end up with nothing if the shadow loans default.

Underground Banks

Underground banks are booming in China. Banks are issuing letters of credit that are off-balance sheet vehicles that do not factor into the sector’s balance sheet leverage ratios. Companies can obtain multiple loans from different banks using the same collateral, thereby making it difficult to determine how leveraged these banks really are.

Government Action

Wealth management products have borne the brunt of the criticism of the shadow banking system, with Bank of China chairman Xiao Gang calling the products a Ponzi scheme in an op-ed in the China Daily newspaper.  Wealth management products fund projects such as property development or infrastructure that cannot access funds through normal loan channels. Investors may not have any idea about what the investment is or what kind of returns they can generate. The products are riskier than deposits, but investors believe that banks back them as they are marketed in most bank branches. If the products default, banks’ reputations will take a hit.

China’s shadow banking system is very complex and poses tremendous risks to the conventional banking system because of these systems’ intertwined relationship.  Given the shadow system’s size and significant place in the economy, China could face economic turmoil if the shadow banking system collapses.