Why shadow banking may never be properly regulated

In 2013, shadow banking – unregulated, high-yield lending that largely takes place off banks' balance sheets – reached a record 30% of total financing in China. Total debt (encompassing central and local governments as well as corporate) now stands at over 200% of GDP.

The government believes that placing too many restrictions on shadow activities further threatens the country's economic growth. This under-regulation has allowed the industry to mature and diversify, and subsequently engage in higher risks.

“There is an implicit assumption that if things got really bad, the government or somebody will step in and fix it,” one expert told China Law & Practice.

“When there has been perceived to be a stress, they've managed to come in and rescue the situation without causing collapse in the confidence of the market or retail customers,” he added.

The recent and mysterious Rmb3 billion bailout of ICBC and China Credit Trust's product supports this assumption.

Mixed messages from government

This ambivalent attitude has led to some half-hearted attempts at regulation. In January the State Council issued Document 107, a carefully crafted document that is limited in implementation.

The document stated that shadow banking encompasses any companies that do not hold financial licences and are unregulated or unsupervised, as well as those that hold a licence but do not possess adequate supervision, including money market funds, asset securitisation, and some types of financial businesses.

“It has not been viewed to encompass banks, trusts, or interbank market activity – areas that currently require the most additional regulatory control due to their large scale and risky nature,” said Sara Hsu, an economics professor at SUNY New Paltz.

“There's some sort of mismatch between the perceptions of the players and regulators regarding whether trust and wealth management products are part of shadow banking,” she added.

“The authorities want to regulate the sector without killing the players,” said XuSheng Yang, the founding partner of FenXun Partners.

Regulatory conflicts

Some of the attempts to regulate the industry so far may have actually increased the use of certain products.

In March 2013 the China Banking Regulatory Commission [CBRC] issued Document 8, which had the effect of recognising, rather than eliminating, non-standard debt assets like trust and wealth management products. This official acknowledgement gave the industry a go-ahead to push things further.

“The fact that CBRC actually set a limit for these products implies they are allowed, as opposed to before when they weren't mentioned at all,” Yang explained.

The CBRC then issued Document 9 in November, aiming to restrict inter-bank lending activities. Despite the inclusion of workarounds, banks fought back against the policy – an indication that large parts of the shadow banking industry will fight any attempts at meaningful regulation.

“Such trust companies rely on the shadow sector for business, so they don't want to see the situation resolved,” he added.

Given the challenges of regulating such a diverse industry, a coordinated effort of all agencies is needed. “One regulatory body can't tackle this issue alone by traditional means. It's about coordination among all the bodies,” said Yang.

While experts agree that the securities and insurance bodies regulate shadow activity (the use of wealth management products) relatively well, the CBRC, which is supposed to regulate banks and trusts, is running into conflicts of interest. Such a fragmented and incoherent regime creates risks for all users.

Growth without debt

2008 to 2013 marked the sector's prime growth period as shadow banks loaned to real estate and industries that built up fixed asset investment. The debt trap has arguably reached its peak, as real estate profits are declining and analysts are becoming increasingly wary of the perils of shadow banking.

This has led some to question whether the problem might die out on its own. “Further regulation therefore would be prudent, but if it doesn't happen, the need will die out as the shadow banking system decays,” said Hsu.

She said that the key was to ensure that future economic growth is not fuelled by debt. “Growth needs to come from a coordinated central government policy that focuses on key specific industries capable of moving the economy forward.”


By Katherine Jo