Beijing is looking to reduce the scope of risky shadow banking operations, yet the sector is vital to country's economy. How can regulators act without destabilising a key source of finance?

Shadow banking cover

Behind the back of China’s massive on-balance-sheet lending activities and robust asset classes, you find another world populated by high-risk borrowers, such as smaller companies overlooked by the state-owned banks, and microlenders stepping into digital finance. Hidden in plain sight, China’s shadow banking industry has a size and scope some countries could only dream of for their mainstream banking sectors, providing a significant boost to China’s gross domestic product (GDP). However, the ever-present risk of contagion from economic shocks and bad assets is too great for the regulators to continue to turn a blind eye towards. 

A pivotal moment came in December 2020 when the China Banking and Insurance Regulatory Commission (CBIRC) defined for the first time what officially falls within the bounds of shadow banking. The “China Shadow Banking Report” defines shadow banking as credit activities that were outside the banking supervision system, and which apply credit standards that are significantly lower than those which are applied by the banks. 

Sectors which fall under the definition were interbank special purpose investment vehicles and interbank wealth management; wealth management products, such as non-standard debt, entrusted loans, trust loans, online lending and peer-to-peer (P2P) loans; and non-equity privately-raised funds.

The report further noted complex business structures, incomplete information, low transparency, and excessively high leverage as components of shadow banking. 

To tackle these issues, the report recommended several steps, including dynamic assessments of the scope and forms of shadow banking, the clarification of distinctions between publicly and privately offered products, and ensuring full regulation that is unified across institutions and comprehensive coverage to prevent blind spots. 

Gaining a better understanding of the shadow banking space has been a goal for the regulator since the sector peaked in 2017. Estimates from the CBIRC put the size of China’s shadow banking assets at Rmb84.8tn ($13.04tn) at the end of 2019. This number represents a 16% fall from its peak of Rmb100.4tn in 2017.

The numbers are, however, creeping back up. A report published by Moody’s Investor Services in January 2021 found that shadow banking assets increased by Rmb700bn in the first three quarters of 2020. This increase followed a decline of Rmb2.3tn seen during 2019. 

SMEs in rural areas... are most likely to look to shadow banking credit, as their credit profile is not sufficient enough to access [traditional] funding.” 

Lillian Li, Moody's

According to the report, the increase was brought about by asset managers and undiscounted bankers’ acceptances, coming from the delay in tightening rules around asset management in a bid to buoy up the economy during the pandemic. Meanwhile, other core shadow banking sectors, such as trust loans and entrusted loans, shrank. 

Yu Lingqu, deputy director of China-based think tank the China Development Institute, says: “The make-up of shadow banking can be seen in two parts. There are the high-risk shadow banking options, such as trust loans, which saw little growth. However, lower risk products saw more significant growth. Overall, this meant the risk was manageable.” 

Lending activity down 

Even with some risks being manageable, in other areas they were creating real worry. In the early days of the pandemic, concerns rose that the trust industry was facing a crisis as the number of defaults was predicted to rise. This became apparent in March 2020 when shadow lender Anxin Trust required assistance from the government to avoid systemic financial risk. The company was believed to have a financial deficit of Rmb50bn. 

Trust companies operate by borrowing funds from wealthy investors and lend with interest rates to companies often in higher risk industries, which struggle to get conventional bank loans. 

CBIRC stepped up in June 2020 to prevent a number of trust companies from conducting business by offering loan-like trust plans. Others were required to reduce the volume of their business by at least 20%. 

Even with these steps, the importance of the overall shadow banking space in shoring up an economy which had been savaged by the pandemic was not overlooked.

Mark Kruger, senior fellow at the Centre for International Governance Innovation (CIGI), says: “The shadow banking system arose because financial institutions were eager to find ways to work around existing regulations, in order to provide financial services to under-served segments of the economy.” 

Chinese banks prefer to lend to state-owned enterprises and local government financing vehicles, as these borrowers are implicitly backed by the government and loans to them are therefore assumed to be low risk, Mr Kruger explains. Lending to some sectors, such as property development, was restricted by the regulators. 

Mark Kruger

Mark Kruger, CIGI

“This banking on government guarantees means there are a lot of profitable private firms which are unable to access credit, as the banks don’t have the incentive to do the credit assessment and take on the risk,” Mr Kruger says. “Initially, in the aftermath of the financial crisis, the authorities tolerated the shadow banking system as a way to broaden access to credit and support the recovery.”

Years later, these funding sources are still providing an essential lending service. Putting too many measures in place would be restrictive, especially as the Chinese economy faced another crisis. 

In some instances, it was perceived better to permit shadow banking activity which would help the overall economy, than to take the GDP hit. Mr Yu says: “During 2020, shadow banking regulation was loosened to stimulate the economy, even though there were risks. But as the funds were going into the real economy, the decision was made to take on that risk.” 

Lillian Li, vice-president and senior credit officer, credit strategy and research at Moody’s Investors Service, explains: “The bank policies saw some relaxation last year, especially in the criteria relating to small and medium-sized enterprises (SMEs). This encouraged a large increase in the credit flows from smaller banks to these companies. P2P and online lending both faced greater scrutiny. While loans from online lenders increased, the number of companies declined.” 

Asset quality slide

The size of the sector places pressure on the quality of the assets held in China. Figures from the CBIRC released in December 2020 estimated the size of the shadow banking space in 2019 to have been the equivalent of 86% GDP and 29% of China’s total banking assets. 

Rowena Chang, associate director, non-bank financial institutions — Asia-Pacific at Fitch Ratings, is not optimistic about what has taken place over the past year. “In terms of asset quality, I think this has further deteriorated in 2020. The main source we used to track this was the trust companies, as this is a major source of shadow banking activity. From the data available we can see that the risky projects already accounted for 3% of total trust assets under management in the first quarter of 2020. This is compared with only 1% and 2.7% at the end of 2018 and 2019, respectively. While the trust association has stopped disclosing the number of risky projects, we can see the trust companies are making greater reserves for total loss compensation, so is likely to indicate the total asset risk is still on the rise.” 

Due to coronavirus, plans on asset classification have been postponed. Ms Chang says: “There was a new asset management rule implemented in 2018, giving the deadline for the asset managers to compile their assets by the end of 2020. But, given the pandemic and the economic pressures in China, they have extended it to the end of 2021.” 

The difficulties many companies faced due to the economic downturn during the pandemic have created the possibility of a decline in credit quality to come. Mr Yu says: “Last year, we did see some companies and industries in China did not do very well, which will result in a higher default rate. This is putting pressure from the real economy onto the financial industry. We have seen this impacting the automobile manufacturing sector, and coal and mining companies.” 

Digital banking threat 

While the regulators were contending with the trust companies, the risk from emerging digital lenders was rising. For borrowers who had been unable to access credit through the banks, these new companies gave them the assistance they needed, even if the source was not ideal. 

“P2P lending in China was a response to the difficulty in getting a loan from the formal financial system,” Mr Kruger says. “It has received a lot of press, but it was never a huge source of credit. At its peak, it accounted for less than 1% of total bank lending. By the end of 2019 it was less than a third of 1%, so it was not a systemic risk. The regulators have cracked down on P2P lending because of problems with fraud — they saw it as more of a social problem.” 

What we’ve seen in China is what we often see globally: financial firms are quite innovative and regulators are often left playing catch up

Mark Kruger, CIGI

But the concern has now spread more broadly, and into areas that account for a sizeable proportion of overall lending. Mr Kruger says: “More recently, the regulators have taken aim at internet platforms like Alibaba and Tencent. These two private firms essentially have a duopoly over Chinese retail payments. As they branch out into other financial services — like consumer lending — the regulators want to ensure that they abide by the same prudential rules as other financial institutions.” 

New online lending rules were announced at the beginning of 2021, outlining that this area accounts for no more than 50% of total lending for commercial banks and co-operative institutions, to reduce the risk of excessive online lending growth for banks with higher exposures. There are further rules on outsourcing aspects of controls on online lending, a point which will hit regional banks that had relied on online microloan lenders for underwriting standards for online lending. 

While the larger banks are unlikely to be impacted, these rules are a blow to the smaller lenders and the online microloan companies. Fitch reported that the latter lenders accounted for around 2.8% of all banking assets, but accounted for around 14% of household loans. The concern is that the problems they face could tip over into the bank space due to the partnerships needed to conduct their business, which is often with the smaller, regional banks. 

The launch of the People’s Bank of China’s (PBOC’s) central bank digital currency (CBDC) also comes as part of the campaign to reduce the influence of the big digital players, who are able to tap into massive customer bases. Tencent’s WeChat alone has more than one billion users. 

“The CBDC has been developed after the emergence of online trading platforms like and Alibaba,” explains Du Yang, former vice-chairman of the Chinese Asset Management Association of Hong Kong. “This includes a wealth management business that has come with the capital accumulated in the digital sphere. Tian Hong Fund, controlled by Tencent, is bigger than ICBC in terms of assets under management, and all its funds are gathered through WeChat Pay.” 

Renewed focus 

Activities in the shadow banking space are certainly giving the regulators plenty to work on, especially thanks to having what is largely considered to be the world’s leading digital payments and banking sector. 

“What we’ve seen in China is what we often see globally: financial firms are quite innovative and regulators are often left playing catch up,” says CIGI’s Mr Kruger. “In China, overseeing financial innovation has kept the regulators busy. They strengthened the oversight of the shadow banking system, tightened the rules on P2P lending and are now grappling with internet finance.” 

The announcement of the official definitions is a strong signal of the renewed focus from the regulator, according to Moody’s Ms Li. “Tightened restrictions since the second half of last year have led to changes in thresholds of the online lending and lending from microloan companies, with the financing provided by the likes of Alipay much lower than it had been previously. This has had some impact on customers on lower incomes. The greatest impact comes to the smaller SMEs in the rural areas. These companies are most likely to look to shadow banking credit, as their credit profile is not sufficient enough to access funding in the banking sector.” 

Lillian Li

Lillian Li, Moody's

Zedric Cheung, associate analyst at Moody’s, says the regulations are already having an impact. “The P2P lending sector was officially terminated in November 2020. Also, new regulations on microloan companies were published which contained requirements on these companies’ leverage and business scope. It is expected these regulations will be further tightened this year.” 

Undoubtedly, the regulatory space will adapt to meet the next set of challenges. Annie Ao, director at S&P Global Ratings, says: “Several rounds of industry-wide reviews, onsite visits and reporting have been conducted to identify key risks in the underlying assets and deficiencies within the internal control systems. The regulatory framework has also been updated to mitigate risks around product design, leverage limit and information disclosure. In the meantime, regulators continue to refine their monitoring systems with timely information that can be collected on asset types, volumes and underlying risks.” 

Fitch’s Ms Chang notes that since shadow banking has declined around 30% since its peak, the regulations are not primarily about reducing the scope of the sector. “It is more about creating a regulatory framework to cope with an increase in credit events,” she says. 

Grace Wu, senior director, banks — Asia-Pacific at Fitch Ratings, says the rules are creating a more stable banking environment. “We think a lot of the tougher rules around online lending and property lending caps along with the broader pace of economic recovery in China is coming together quite nicely for the operating environment,” she says. “The good news is that despite the Covid-19 pandemic and the increase in leverage, the government has not had to use credit stimulus to boost economic growth. We felt that it was a commitment to maintaining stable system leverage.”

Here to stay 

Even with these curbs in place, the shadow banking sector is unlikely to disappear any time soon. 

“Although the level of shadow banking has declined, with a current asset value of around Rmb85tn, it is still quite large,” Mr Yu says. “Therefore, the efforts to curb the sector will continue in order to further decrease the size of the sector and to control risk.” 

It is possible the sector will remain at close to its current levels. “In our view, China’s shadow banking assets are unlikely to grow over the near term, thanks to previous rounds of clean-up, more stringent rules and continuing surveillance,” says Ms Ao. “Even if the shadow banking financing activities pick up again in the future, the asset quality will likely improve. However, we believe more trust product defaults are likely to happen this year, mainly due to legacy exposures.”

Instead, it may be more appropriate to think of shadow banking as a sector which will continue to evolve, rather than vanish altogether.

“It is best to think of it as non-bank credit intermediation going forward, instead of shadow banking, as once they have cleaned up the irregular lending activities, non-bank credit will still be important in providing financing options outside of the banking system,” explains Ms Chang. “In the past, these facilities have been used to disguise bank’s non-standard lending activities, and these have been masked with multiple investment layers. This makes it difficult to track the asset quality of the underlying credit assets.” 

The size of the sector outlines the need for funding among the underserved parts of the banking space. The goal is to put this funding into a transparent space. “The regulations will ensure that funds are put into the standardised markets, which in turn increases the amount of funds in the market that are available to lend. This will make it easier for companies to obtain the funds they need,” Mr Yu adds. 

The economic goals of the government mean it is hamstrung by its need for shadow banking in order to reach its own financial targets. 

“The government has set itself sizeable GDP targets to coincide with the 100th anniversary of the Communist Party,” says Mr Du. “To achieve these requires a lot of trade offs. I don’t think the PBOC will significantly reduce the size of the M2 [money] supply, because there are certain sectors which need to be satisfied. There are also additional costs from the need to create 11 million new jobs. And the risk of Covid has not yet disappeared.” 

Shadow banking is likely to continue to hold a place in the Chinese banking sector, at least as long as the lingering risks from the pandemic remain. Mr Du says: “Overall, I don’t think the size of shadow banking will be reduced dramatically, as the national economy still needs it. It is more realistic that the GDP goals will be reached if the banking sector can continue providing support. There are attempts to shrink the size of lending in the long term, but that won’t happen before the end of the year.”


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