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The shadows are lengthening in the financial sector

The global financial crisis is still with us. Its onset was unpredicted, its ramifications unpredictable. But at its heart was what otherwise discredited former American Secretary of Defense Donald Rumsfeld termed “unknown unknowns”.

What was unknown in the crisis was the degree to which “known unknown” risks – those known to exist but unknown in magnitude - in different sectors of the financial system would interact with one another. And it was this opaque network of credit risks and relationships which typified what came to be known as the shadow banking system.

"The issue implicit in recent reports and books is shadow banking is still in the shadows."
Andrew Cornell, BlueNotes managing editor

The global policy response, coordinated by the Financial Stability Board (FSB), has been to cast light into the shadows, turning shadow banking into the more benign – indeed beneficial – non-bank or market-based financing system.

Yet the light has not yet shone everywhere. Emerging markets – and China in particular, given its size and centrality to global growth forecasts and anxieties - have a lot of observers peering nervously into the shade.

VULNERABILITIES

The Bank for International Settlements, home of global financial system regulation and the FSB, analysed International capital flows and financial vulnerabilities in emerging market economies in a new BIS Report.

“A number of important data gaps still exist,” the report found. “The first major data gap is related to underlying corporate exposures. (The data) provide useful information on the currency composition and maturity structure of corporate liabilities.

“However, the data are inadequate for hedging activities and other derivatives-related positions. In addition, there are no international data on corporates’ financial assets (currency composition and maturity, banks as counterparts, holdings of shadow banking products, etc).”

Critically, it is not just a regulator’s insatiable inquisitiveness at issue, the opacity goes to the heart of the risk: “This contributes to the uncertainty about the volume of foreign currency exposures, the links with the banking system and the degree to which hedging reduces systemic risk.”

Now a new book has just been published on the financial risks shadowing China. Shadow Banking in China: An Opportunity for Financial Reform, by Andrew Sheng and Ng Chow Soon from the Fung Global Institute, (Wiley), reveals the scale of the sector in China.

It is enormous. According to the FGI and Morgan Stanley, total alternative financing grew from RMB6.9 trillion to RMB28.4 trillion between 2007 and 2012. Total bank loans grew from RMB27.8 trillion to RMB67.3 trillion.

That is, in the five years to 2012 bank finance grew at a peak of 33 per cent 2008-2009 and 16 per cent 2011-2012. Alternative financing grew at a peak of 72 per cent 2009-2010 and 45 per cent 2011-2012. And that’s just until 2012.

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There are large risks. The authors noted in a launch of their book “while less leveraged / sophisticated by global standards, the sharp rise in China’s shadow credit since 2007 threatens systemic stability”.

They identified some key risks:

• Corporate leverage and opaque bundling of credit risks between shadow and formal banks.

• A sharp slowdown and property price correction triggering higher non-performing loans (NPLs) and liquidity pressures in the weakest sectors.

• The “moral hazard” of state bail-outs.

UNOFFICIAL

‘Unofficial’ lending is particular opaque. The Financial Times this week ran a story on some of China’s largest resources corporations and shipbuilders “searching for higher returns in the unregulated lending industry as their core businesses struggle with overcapacity and an overall slowdown in economic growth in the country”.

According to the FT, “analysts have flagged the rapid growth of entrusted lending among large companies, mainly state-owned miners and heavy manufacturers, as a worrying trend and a potential contributor to China’s bad-debt problem”.

“We believe that these non-financial [state-owned enterprises] do not have the expertise to operate like a bank and evaluate the creditworthiness of the lender, and it is likely that these loans would become non-performing as the economy slows further,” Chua Han Teng, an analyst at Fitch’s BMI Research, said in a report.

This is quintessential “shadow” banking. So-called entrusted loans are loans made from one company to another, “vaguely resembling the banking industry but without the risk controls that licensed lenders exercise when making credit decisions” in the FT’s words.

The FT cited research showing some of China’s biggest industrial companies are now entrusted lenders.

“The aggregate stock of entrusted loans in China hit RMB12.06 trillion in June, an increase of 20.8 per cent from the year before, making it the fastest growing segment of core shadow banking in the country,” the FT says. “Entrusted lending has grown by 70 per cent since the start of 2014.”

So how big a risk is the shadow sector in China, both in its own right and as a source of contagion in the region?

According to Sheng and Ng in their book, not huge. They argue only 20 to 40 per cent of shadow loans could contaminate the banking sector and even in a “disaster” scenario that would only push banking sector NPLs to 7 per cent.

“Systemic crisis is unlikely as China has adequate resources and policy space to address domestic debt problems,” they say. Nevertheless, other risks, more difficult to estimate, exist, such as derivative positions – where the FSB still sees data gaps – and the re-packaging of high risk lending for sale to unsuspecting investors.

LESSONS

This was another lesson of the financial crisis: while in theory the slicing and dicing of bundles of sub-prime mortgage was supposed to lower aggregate risk, leaving those prepared to take the risk holding the assets, in reality complex structures hid the risk and the investors who least understood them ended up holding them.

One of the acute threats in the crisis was not a bank but an insurance company – AIG – which had insured much of the risk and whose collapse would likely have triggered even more severe waves of crisis.

In China at the moment we are seeing complex structures emerge such as bundling via trust companies of what are called wealth management products (WMPs).

Sheng and Ng argue while China can currently cope with the threat of shadow banking and it is largely a domestic issue, they say there needs to be immediate reform and much greater transparency.

But they maintain China’s sovereign government balance sheet showed a net asset position of RMB103 trillion in 2013 (162 per cent of GDP); the state has ample net assets and policy space in fiscal and monetary policies to deal with any shadow banking problem; however, any restructuring of debt must come with strong discipline to avoid moral hazard, restore credit culture and transparency of accountability.

In this they are in essential agreement with BIS proposals as laid out in its Transforming Shadow Banking into Resilient Market-Based Financereport.

The focus of the FSB’s work is systemic threats: “the approach is designed to be proportionate to financial stability risks, focusing on those activities that are material to the system, using as a starting point those that were a source of problems during the crisis”.

It also provides a process for monitoring the shadow banking system so that any rapidly growing new activities that pose bank-like risks can be identified early and, where needed, those risks addressed.

This is all good stuff. The issue though, implicit in the recent reports and books like Sheng and Ng’s, is shadow banking is still in the shadows. We might have moved the risk from unknown unknown to known unknown but there are still potentially catastrophic data gaps.

Meanwhile, as the emergence of entrusted lending shows, in a low-growth, low-yield world with high liquidity, risks are growing faster in the shadows than in the traditional financial sector and we still don’t understand enough of the embedded risk.

Andrew Cornell is managing editor at BlueNotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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