What we know about China and Shadow Banking

An interesting speech last week from Marisa Lago, Assistant Secretary for International Markets and Development at the US Treasury, offers the US view on Shadow Banking activity in China. It also highlighted areas where the US Treasury is concerned about China’s financial market evolution. Excerpts from the speech follow, along with our commentary.

“In China, financial intermediation outside of the regulated banking system has grown rapidly over the past few years. This poses new challenges to financial stability. Controls on interest rates have resulted in negative real deposit rates for Chinese households for much of the past several years. As a result, Chinese investors have sought higher yields in less regulated products, particularly wealth management products. Analysts have raised concerns about the strains that these wealth management products can put on banks’ funding and liquidity. This is a special concern for smaller banks that have narrower deposit bases and more limited access to interbank credit. Many small and medium enterprises (SMEs) that do not have access to lending from regulated banks have turned to informal lenders, which charge much higher interest rates and often involve complicated loan guarantee schemes.”

So, negative real interest rates mean that China may have the same problems as Denmark and Switzerland, but the state control of the system can offer protections. Still, smart and wealthy investors are chasing yields through leaning on non-bank and bank balance sheets.

“I understand that Chinese regulators are also focused on managing the heightened risks posed by these particular institutions and financial products. This is a welcome development, and as our experience shows, shadow banking is a phenomenon that merits close attention. As long as interest rate controls exist alongside financial innovation, both investors and borrowers will continue to seek out riskier, less regulated and innovative financial products.”

While not focusing on securities lending and repo per se, the US Treasury is keening interested in China’s non-bank financial markets. We have no data on the size of each relative market, but Ms. Lago’s comments echo an op-ed piece by Xiao Gang, Chairman of the Board of the Bank of China, published Nov 12, 2012 in the China Daily. In the article, Mr. Gang said “in China, shadow banking has mainly taken the form of a large amount of wealth management products, or WMPs as they are known, underground finance and off-balance-sheet lending…. China’s shadow banking is contributing to a growing liquidity risk in the financial markets…. In order to prevent China’s financial systemic or regional risks from happening, it is imperative to pay more attention to shadow banking and to enhance supervision over shadow banking activities.” This is heady stuff. (Incidentally, we saw that ZeroHedge covered this op-ed piece as well.)

On resolving a failed financial institution: “In China, a more comprehensive resolution regime is needed to provide regulatory authorities with the operational autonomy and legal authority to intervene promptly in weak or nonviable financial institutions. We appreciate that China has been working carefully on the introduction of an explicit insurance deposit scheme, and we believe that China’s work in this area is a valuable part of providing a structured safety net. Such a formal safety net would replace the current blanket government guarantee for depositors, an implicit guarantee that carries significant moral hazard.”

Does the US want to push the new Orderly Liquidation Authority as a model for China? Probably, but not too aggressively.

The full speech by Ms. Lago is here.

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