Shadow Banking in China: Implications for Financial Stability and Economic Rebalancing

Home , Shadow banking system

Prepared for Economics Seminar, Portland State University, May 22, 2015

Yan Liang Willamette University Outline

1. Fast Growth and Increasing Size of Shadow Banks;

2. Shadow Banks: Major Institutions and Activities;

3. Causes of Shadow Banking Growth;

4. Shadow Banking, Credit Expansion and Financial Fragility;

5. Shadow Banking and Macroeconomic Rebalancing;

6. Conclusions Estimates of China’s Shadow Banks

Date RMB (tn) USD (tn) % of GDP GFSecurities 12/17/12 30 4.8 57% Citi Research 1/11/13 28 4.5 54% Barclays Dec. 2012 25.6 4.1 49% Hua Tai Securities 12/14/12 25 4 48% UBS 10/16/12 13.7-24.4 2.2-3.9 26-46% ANZ Bank End 2013 30 4.9 51% Bank of America Merrill Lynch 7/6/12 14.5 2.3 28% Source: Federal Reserve of San Francisco (2013); The Economist (2014) Although the size of the shadow banks is still relatively small, the sector has experienced immense growth since 2008;

Shadow banks have quadrupled since 2008, with an annualized growth rate of 34% since the end of 2010. According to Financial Stability Board (2013), the size (as a percent of GDP) of China’s non-bank ﬁnancial intermediary (a proxy for “shadow banks”) grew by 45% in 2012, the highest among all 25 countries/areas it examines. Shadow Banks: Major Institutions and Activities Shadow banking system consists of a web of specialized ﬁnancial institutions that conduct credit, maturity, and liquidity transformation without direct, explicit access to public backstops (Adrian et al 2013).

shadow banks include: Bank off-balance-sheet activities: undiscounted bank acceptance bills, informal securitized loans and other credit-based assets through wealth management products (WMPs); Bank acceptance bills are issued by banks (upon the request of firms) that provide unconditional payment to the holder of the bills at maturity; Trusts and trust-bank cooperation: trust loans, entrusted loans, WMPs; Trust loans are loans arranged by trust companies and entrusted loans are lending from one company to another through the intermediaries of banks or trusts; Numerous others: leasing companies, finance companies, loan guarantee companies; micro finance lenders; underground banks; person to person lending; and pawn shops.

“Total Social Financing” by the ofﬁcial account provides an imperfect measure of shadow banks (Borst 2011). Growth of Total Social Financing, by Components, 2013&2014

Domestic Equity Undiscounte d Bankers' Financing Equity Acceptances, Undiscoun of Non- Financing -1% ted Corporate ﬁnancial (domestic Bankers' Bonds Enterprise stock Acceptanc 11% s Corporate market), 3% es 1% Trust Bonds, 15% 5% Loans, Trust 3% Loans 11% RMB Loans Entrusted 53% Entrusted Loans, 16% RMB Loans, Loans 62% 15%

Foreign FX Loans, Currency 2% Loans 4%

Note: Total TSF in 2013 and 2014 are $17.3 and $16.4 trillion yuan, respectively. Source: People’s Bank of China Trusts: now second largest non-bank financial institutions, asset under management (AUM) has increased fivefold since 2010 to reach 12.5 tn yuan as of 2014Q2. Trust loans made up for 11% of TSF in 2013 (fell to 3% at end-2014). Trust also intermediate “entrusted loans” and accounted for a total of 40% WMP distributions during 2004-14. Trusts rely on bank lending, and use banks to distribute trust products (fivefold increase during 2007-9). Banks use trusts to arrange “entrusted loans” and invest in trust products (in some cases, engage in “disguised” interbank lending).

Wealth Management Product (WMP): informal securitization of loans and other credit-based assets to attract and retain deposits and to evade loan-to-deposit and capital requirements in order to expand lending. As of 2013Q3, outstanding WMP reached 9.9 trillion yuan, or 18% of GDP. deposits in recent years, as shown in Figure 6. Since the management, real estate investment, and private equity underlying assets are often of much longer maturities, issuers investment. need to roll over WMPs on a continuous basis to maintain a Before 2007, trust companies were known as trust positive cash flow. investment companies (TICs) and specialized in credit Figure 5: Maturity of bank-issued Figure 6: Rising volatility in deposits extension to private enterprises. Local governments also WMPs (2012) RMB trillions used lightly regulated TICs to finance long-term, risky real Not 3.6 2.5% estate and infrastructure projects, which led to a rapid Above 1 specified year <1% Up to 1 deterioration of TICs’ asset quality in the early 1990s 2% month 2.4 2.0% 5% when the economy experienced a downturn. The trust 6 month- 1 year 1.2 1.5% sector subsequently experienced several dramatic booms 13% and busts, followed each time by aggressive regulatory 0 1.0% steps to clean up problem assets and improve risk

3-6 month management. In 2007, the entire sector underwent 25% 1-3 month -1.2 0.5% 55% '07 '08 '09 '10 '11 '12 restructuring and consolidation, with only 54 trust companies remaining in business, down from more than Monthly change in deposits (left axis) Rolling 12m standard deviation of monthly 2,000 at their peak in the early 1990s. The overhauled trust % change in deposits (right axis) Source: CNBENE. sector quickly gained momentum after the global financial Source: People's Bank of China. crisis, with their assets under management (AUM) More than 60 percent of all bank-issued WMPs have no growing six-fold between 2007 and 2012, reaching RMB guarantee on either rate of return or principal payments, as 7.5 trillion (USD 1.2 trillion) by year-end 2012. shown in Figure 7. External credit enhancements to WMPs Trust companies and banks are interconnected through usually take the form of principal guarantee. Typically, ownership and business operations. It is common practice Chinese guarantors are private, small in size, and only have for banks to own controlling shares in trust companies. limited capital to cover potential losses. It is unclear whether Furthermore, in the so-called “bank-trust cooperation existing guarantees could effectively reduce credit risks for model,” banks channel funds to trusts via entrusted loans; investors. Although an explicit deposit insurance construct trusts make high-yield loans to risky or small borrowers does not exist in China, Figure 7: Bank-issued WMPs by that have difficulty directly obtaining bank credit. By market participants often type of guarantees (2012) engaging in this type of cooperation, banks are able to consider bank deposits as Fixed return “outsource” part of their lending business to trust implicitly 100 percent 14% companies and move these loans off their balance sheets. guaranteed by the Min. return In 2010, bank-trust cooperation accounted for nearly two- government. Many individual guaranteed thirds of trust assets. Although on the decline because of 4% investors are under the subsequent regulatory tightening, this segment still impression that bank-issued Non-principal represents a significant share of trust assets—27 percent as WMPs are implicitly guaranteed, floating return Principal of year-end 2012. Figure 8 illustrates the trust companies’ guaranteed by the government 63% guaranteed, floating return connection with banks. as well, since they are sold at 19% bank counters, which can lead Figure 8: An illustrationAn Illustration of trust of Bank-Trust companies’ Cooperation business model to an underestimation of the Banks Source: CNBENE. riskiness of these products. Deposit Bank depositors The CBRC is closely monitoring bank-issued WMPs. In (individual Entrusted Purchase bank investors) loans acceptance bills 2011, it published the “Guidelines for Commercial Bank- Bank- issued Trust assets Issued Wealth Management Products,” which took effect in Purchase WMPs Invest Loans, bank Stocks, bonds, 2012, to outline a regulatory framework for these products. In Qualified wealthy Loans acceptance bills, ETFs, PEs… March 2013, CBRC announced additional rules to regulate individual investors letters of credit, Purchase Trust Invest etc. Products bank-issued WMPs, requiring substantial improvements in Entrusted Trust Indirect Institutional loans loans credit extension accounting transparency, disclosure, and auditing practices. investors, SOEs, Purchase However, given the absence of centralized data on WMP LGFV, banks Real sector LGFV SOEs issuers and underlying assets, the risk/return profile of the Real estate investments is not clear. developers Households Informal lending SMEs

Trust companies WMPs have become a fast growing source of funding for Shadow banking credit in China is often extended through the trust sector after 2010. Banks issue WMPs, and invest trust companies, the largest group of nonbank institutions in a large share of the proceeds in trust projects. Trust China as measured by total assets. Trust companies engage in companies also issue WMPs independently, often using a wide range of businesses including lending, asset Outstanding Wealth Management Products (RMB Billions) and as Percentage of GDP 10000 20 WMP outstanding 9000 18 8000 Percent of GDP 16 7000 14 % 6000 12 5000 10 4000 8 RMB Billions 3000 6 2000 4 1000 2 0 0 3. Causes of Shadow Bank Development

“Financial Repression”? WMPs are often considered as safe as bank deposits. As long as WMPs are offered by banks and pay a higher interest rate than bank deposits (2X-4X), there will be demand. So even if interest rates are liberalized, there will be still high demand for WMPs. So ﬁnancial repression is not the only answer.

Demand-side: savers/investors seek high yield investment venues (underdeveloped bonds and equity markets); small- and medium- sized enterprises need ﬁnancing;

Supply-side: banks’ incentives to evade regulations (loan quota, capital requirements, sectoral exposures, etc.); cash rich SOEs (with access to cheap bank credit) engage in “carry trade”;

Surge in shadow banking driven by credit expansion in 2009 then tightening in 2010. 4. Shadow Banks, Credit Expansion and Financial Fragility

Institutional Risks: Trusts Low capital requirement (200 mn yuan or 10% of net assets in 2010) to set up trusts; high leverage ratio (40X!) (IMF 2014); very opaque - only 29 (out of 66 registered trusts) disclose capital, and most (except for two publicly listed) failed to report returns (China Trustee Association); Make risky investment to infrastructure, real estate, local gov’t funding vehicles (LGFVs) and industries with excess capacity; Fund pooling and “ever-greening” WMPs -issue new WMPs and use the proceeds to either pay for previous obligations or continue lending to dodge non-performing loans. . Trusts: AUM to Equity Ratio

45 All 40

35 Top 10 by AUM

0 2004 2005 2006 2007 2008 2009 2010 2011 2012 Financial Fragility: Institutional Risks, Cont’d

Bank WMPs: Majority are loan-based (40-50% vs. Regulatory decree of 35%) and the number of loans is limited; so credit risk diversiﬁcation is weak; No rating system, no tranching based on credit risk, no secondary market; so liquidity risk is excessive; Maturity of WMPs is shortening. In 2007, less than 10% were less than 90 days, and more than 50% were a year and above; by end 2010, about 40% were less than 90 days and <20% were a year or over; but funds raised could be invested in long term projects, e.g. real estate; so again, liquidity risk is excessive; Banks often act alone in originating, distributing, custodying and managing WMPs; fund pooling; contagion risks are high – Xiao Gang “ponzi scheme”; Financial Fragility: Systemic Risks v China’s overall debt rose to 142 trillion yuan ($22.8 trillion), or 245% of GDP as of 2014Q1, up from roughly 150% in 2008 (Standard Chartered 2014); v Shadow banks contributed greatly to credit expansion.

Growth Rate of Credit, by Type, y-o-y 100

60 Bank loans Corporate bonds 40 Entrusted loans Trust loans 20 Bank acceptance bills

-20 Total Debt to GDP Ratio by Sector, 2000-2015e Source: PBoC, Gao Hua Securities, Goldman Sachs

300

250 240 219 230 209 200 195 194 181 consumer loans 161 156 155 154 150 149 153 153 Govt leverage 135 138 LGFV leverage 100 Coporate leverage Total debt 50

109 103 107 114 106 98 98 96 97 112 125 129 142 151 163 173 0 Chinese Corporate Sector Performance Source: IMF (2013) 20 7 18 6 16 14 5 12 4 Share of loss-making 10 companies (based on 8 3 negative RoA) Median return on assets 6 2 (right scale) 4 1 2 0 0 Upper panel: Private Credit (in percentage of GDP) in Selected Countries, 2012 (or latest data available)

Lower Panel: Private Credit Growth (5 year change in private credit as % of nominal GDP) in Selected Countries Systemic Risk “5-30 rule”? China’s situation resembles 66 pp credit growth in Thailand and 40 pp growth in Malaysia ﬁve years prior to the Asian crisis; and 46 pp growth in the US in 2002-2007 (Goldman Sachs 2013);

Increasing indebtedness, coupled with potential slower growth and worsened corporate proﬁtability, may make businesses more susceptible to ﬁnancial distress and failure, and it also increases the level of non performing loans (NPLs) for the banking sector. But still, China is unique

State-owned banks dominate; central govt has the capacity to write off bad debt and recapitalize banks. Think the late 1990s;

WMPs as the weakest link; but (ultimate) investors mostly purchase with own savings, low leverage and low risks of distress sales and debt deﬂation;

Tight capital control; external debt is 7.5% of GNI; $3.4 trillion fx reserves. No external calls. 5. Shadow Banking and Macroeconomic Rebalancing

Two “Merits” of shadow banks: (1) lending to SMEs (Companies borrowed 716 billion yuan via entrusted loans in 2014Q1; corporate bond issuance over the same period amounted to only 385 billion yuan (The Economist 2014)) and (2) WMPs boost HH income and hence consumption (Goldman Sachs 2013); or really??

“Credit multiplier” (ratio of nominal GDP growth to total credit growth) decreased from an average of .8 in 2003-8 to .4 since 2009. Half of trust loans in 2012 were to ﬁnance new investment, the other half for reﬁnancing old debt that funded past projects but were no longer contributing to economic growth;

Sectoral exposure of shadow banking may further contribute to imbalances; local gov’t, property developers, and industries with surplus capacity accounted for 70% of trust loans in 2012 (KPMG 2012);

Increasing financing costs and higher debt servicing costs reduce profitability and heighten refinancing needs. Zhang (2013): charge 24% annual rate and still have unlimited demand for loans; 4 times “prime” rate and much higher than the 15% average financing costs faced by SMEs. Median EBIT/Interest Expense by Firm Leverage Source: IMF (2013)

6 2012 2010 4

0 1 1001 Rolling window of 200 companies ranked by debt/asset ratio (low à high) Annual Growth Rates of Interest Expense (2008-12, 5 Year Average) Source: IMF (2013)

China Poland Chile South Africa Mexico Russia Turkey India Philippines Indonesia Thailand Colombia Malaysia Brazil Argentina -5 0 5 10 15 20 25 30 Wealth effect may be insigniﬁcant: ﬁrst, uneven distribution of WMP holdings; second, income effect is probably inferior to substitution effect; and third, riskiness of WMPs renders them a less desirable tool to boost consumption.

Source: World Bank (2014) 6. Conclusions

Rising size of shadow banks and signiﬁcant impacts on the ﬁnancial and productive sectors; more research is called for;

Regulatory options: prohibit shadow banks; patchwork, reactive and fragmented regulatory changes (currently implemented); assimilate shadow banks into traditional banking system (some failed experiments).