Financial industry in the spotlight

The trust companies' business in China is highly cyclical. Trust companies have always been used as a channel for alternative financing as banks are traditionally heavily regulated, but trust companies could work through loopholes in the system to offer credit supply to money-hungry firms that do not have access to banks. In that sense, trust companies in China work exactly as shadow banks, said a recent Nomura report.

The property developers' leverage is high, and will likely be hit hard in the economic down cycle. So we believe that the trust industry is the most vulnerable.

A3 To help control the risks, the government should impose more strict regulations on local financial companies, and improve the transparency of wealth management products, or WMPs. For instance, the China Banking Regulatory Commission, has already requested banks to match WMPs with specific projects, instead of running a so-called fund pool.

We expect the government to tighten policies to control financial risks, and the recent consistent signals from the government on tightening have also reinforced our view.

We expect the government to gradually bring down the growth of the M2 money supply and total social financing throughout the rest of 2013, to tighten controls on shadow-banking activities and financing vehicles of local governments to reduce the risks of the banking system.

Chang Jian economist in China at Barclays Capital

A1 A liquidity crunch emerged in the interbank market with the surging of interest rates to a record high. The People's Bank of China posted two statements in two days to address the interbank market turmoil.

In its second statement, the central bank said it would provide liquidity as needed to banks, thus easing market concerns of a Lehman-style financial crisis.

However, the liquidity crunch is likely to spill over to the broader financial sector and the real economy. We see increased downside risks to our below-consensus economic growth forecasts for the second half.

A2 The liquidity crunch will result in continued tighter liquidity for smaller banks as they struggle for deposits; waves of de-leveraging; tougher financing conditions and defaults and failures of smaller financial institutions.

We would expect financing costs to increase and the availability of credit for riskier borrowers to be curtailed.

While potential systemic risks are evident, the probability of a meltdown of the financial system remains low.

Large banks are well capitalized with healthy liquidity, facilitated by the 20 percent required reserves at the central bank. Barring any run on the banks, their deposits are sufficient to meet the lending demand of an economy growing at about 7 percent.

A3 We expect the ripple effects of the liquidity crunch to move to the wealth management products market, bill financing market and the trust sector, and then to borrowers heavily reliant on the shadow banking sector, such as local governments, small and medium-sized enterprises and developers. This will be felt in the coming months.

Regulations to rein in speculative and risky shadow banking activities look set to remain in place and banks will face pressure, with a large amount of wealth management products maturing.