Shadow Banking in China: Boon to Bane
The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks. Shadow banking, in other words, is a system that is governed by a coterie of financial intermediaries that carry out traditional banking functions like borrowing and lending but in a way that is loosely connected with the traditional functions of depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and ...view middle of the document...
The functioning of shadow banks worked in the following steps:
a) Borrow from investors in short term, liquid markets, so that repaying and borrowing again became an easier bet.
b) Lending the borrowed money to corporations to meet their needs for long term liquid asset needs at higher rates.
c) Using the proceeds to pay back their money market borrowings.
This spread between borrowing and lending was the profit booked by shadow banks. The only catch here is that since the shadow banks come outside the purview of banking regulations , increasing leverage and creating an inflated balance sheet helped them attract more money from various investors/ sectors thereby creating a spread that was higher than that which could be justified.
The primary clients of shadow banks are property dealers and investors in infrastructure companies, which do not get funds easily from regulated agencies. Since shadow banks could provide funds at the drop of a hat the debt numbers of shadow banks far exceeded the capacity of the economy to absorb the same. As a result of this, the collapse of banking behemoths like Lehman Brothers and Bear Stearns became inevitable.
China’s answer to Enron: Beijing’s obsessive opacity
The primary loophole in the Chinese financial system is that local governments are not allowed to borrow, so they set up a facilitating mechanism called Local Government Financing Vehicle( LGFV), which borrows money from the banks ( primarily 80% of the money comes from banks) , while the balance is financed by issuing bonds or raising equity finance. These LGFC’s borrow money from the banks at lower rates of interest and lend the same to projects that do not have access to loans granted by authorized systems at comparatively higher interest rates. Since the nature of such projects is questionable (they could be real estate or trophy projects with political interests), the shadow banking coterie can take the liberty of charging higher interest rates from them. This mechanism can prove to be profitable during a boom period, but during a recession the same projects can lead to serious losses.
The China Banking Regulatory Commission has shed light on the country’s opaque shadow banking sector. It was as large as $5.29 trillion in mid-2013 and equivalent to 80% of last year’s GDP. Shadow banking now constitutes over 53% of its GDP. The rapid growth of the sector has lead to a new set of rules being issued by the regulatory authorities ( Central Bank of China) to limit the interbank borrowing to less than a third of its liabilities while lending to another financial firm shouldn’t exceed 50 % of its Tier 1 capital.
The Shadow Banking mechanism:
The main kind of shadow deposits are known loosely as wealth management products (WMPs). Chinese banks market these high-interest-rate accounts as an alternative to savings accounts, the annual yields on which the government limits to a puny 3%. That’s why customers have been plowing money into them like...