Assessing Risk in China's Shadow Banking System

Sara Hsu

A vague panic has overcome many analysts when discussing China’s shadow banking sector. The sector has even been referred to as a “ticking time bomb” by some. Other analysts say there is nothing to fear in the shadow banking sector. So which is it? Is the risk so high that a shock in this sector might result in a financial crisis? Or is the risk so low that growth will be entirely unaffected?

Looking at the sector from several angles, we try to rate the level of risk in various shadow banking sectors to determine whether this fear is justified. We look at liquidity risk, or whether shadow banking institutions have sufficient cash to repay asset holders in the short run; solvency risk, whether shadow banking institutions can muster up repayments in the long run; and market risk, whether shadow banking institutions are exposed to an overall decline in asset prices

First, we start with trust products, which have of late earned some notoriety. Trust products are based on underlying assets such as loans, stocks, and bonds. These have faced high levels of liquidity risk, with some facing on-time repayment issues. Some trust products became insolvent and had to be bailed out by local governments, while some flagging trust products were eventually repaid. Trust exposure to the real estate sector may result in further delinquencies as real estate prices decline, so that market risk may be a factor of concern. Taken altogether, we can say that the trust sector, which comprises the largest percentage of all shadow banking activity in China, at 11 trillion RMB, presents a medium to high level of risk.

Some wealth management products (WMPs), which are based on various underlying assets, contain trust products, increasing their overall level of risk. Wealth management products sold by banks have faced liquidity and solvency issues where trust products have broached failure, and may face market risk when underlying real estate loans (part of the non-standard asset portfolio of WMPs) encounter problems as the real estate market turns downward. Overall, the 9 trillion RMB WMP market presents a medium level of risk.

Corporate bonds have never defaulted, but one is on the brink of delinquency right now. The 9 trillion RMB corporate bond market has generally been comprised of highly rated debt, but [with the coming roll out of debt by local government financing vehicles, which are structures through which local governments obtain financing, and other markets, the market will likely increase in risk since many local governments have undertaken projects with poor returns. As corporate bond yields are directly affected by the market, market risk plays a role in these types of instruments. As a whole, the corporate bond market is currently low risk, but is moving slowly in the direction of medium level risk.

Bankers acceptance bills, or bills guaranteed by banks for loans between two parties, weigh in at about 9 trillion RMB. Banks back these instruments and will repay if necessary. Despite the fact that some of these bills have been used to finance risky ventures of late (such as real estate development), the bank guarantee renders liquidity and solvency problems a non-issue. Market risk is generally judged to be low, as the bills are diversified in their funding. Risk is low to medium on balance.

Credit guarantee companies guarantee loans to banks and have faced both liquidity and solvency issues. Although first promoted by the state to enhance access to funds among small and medium enterprises, credit guarantee companies have grown in risk and have become increasingly interconnected to other firms. Market risk is low, but in an economic downturn, the interconnectedness of these firms may lead to local solvency crises. The relatively small size of this component of the shadow banking sector at 1-2 trillion RMB, is of some consolation, but the financial fragility posed by this sector induces us to rate the overall level of risk as medium.

The entrusted loans sector is a 2 trillion RMB shadow banking channel that analysts rarely discuss. Although we lack specific information about these transactions that are usually made from a larger corporation to a smaller one, though a bank, we do not believe the liquidity, solvency, and market risks are high since the borrowers are diversified. These larger corporations lend extra funds that they hold in the form of cash, and it may be fair to say that these loans do not threaten their financial security. The overall risk in this sector is low.

In sum, the riskiest shadow banking sectors are the trust and wealth management product markets. These are mainly risky based on the integrity of the underlying loans. Many of these loans were extended through a process of adverse selection, with high risk borrowers like local government financing vehicles showing a willingness to pay high interest rates because they have no other choice. The adverse selection issue will play out in the trust and WMP industries, while shadow banking sectors that have lent to more creditworthy customers (as in the entrusted loan sector) or priced in risk (as in the corporate bond sector) will be shielded to some extent from this fallout.

All of this will soon unfold.