Deregulation key to handle shadow banking

In his first remarks on shadow banking this year, Zhou Xiaochuan, governor of the People's Bank of China, said on Feb 24 that China's shadow banking was not massive but it grew rapidly recently.

The government was cautiously handling the issue by placing effective supervision on shadow banking, he said, as he attended the G20 meeting for central bank governors and finance ministers.

Just a few days ago, Yan Qingmin, vice-chairman of the China Banking Regulatory Commission, also commented on shadowing banking.

On Feb 17, Yan said Chinese banks' wealth management business should not be categorized as shadow banking because such activity is covered by a separate regulatory and supervisory framework, has clear legal status, presents controllable liquidity risks, provides sufficient disclosure and undertakes no involvement in high-leverage operations.

But he also said that some wealth management business that eludes supervision is similar to shadow banking activity - and regulators must remain alert.

What Zhou and Yan said conveyed two messages.

First, they are trying to allay domestic and international fears of a sharp slowdown of the Chinese economy.

The two policymakers are keen to play down the size of China's shadow banking. Zhou clearly said the size was not big, while Yan's remarks on wealth management business served as an apparent attempt to reduce the size of shadow banking.

In China, credit extended by non-traditional loan business is supposed to be deemed as shadow banking. So wealth management business, or at least part of it, is believed to be a kind of shadow banking activity. As of Sept 30, outstanding bank wealth management products were worth 9.9 trillion yuan ($1.63 trillion), according to the CBRC.

A Chinese Academy of Social Sciences report lists wealth management products and trust funds as two basic sources of shadow banking. Based on that definition, the report said shadow banking amounted to 14.6 trillion yuan by the end of 2012. If other non-mainstream sources, such as pawnshops, small-loan companies, private lending as well as asset and securitization management, were taken into consideration, the report said China's shadow banking capital hit 20.5 trillion yuan in a broad sense.

So if wealth management products are cleared as Yan pointed out, the size of shadow banking can be reduced greatly. That helps dismiss recent speculation that China's financial system will encounter systematic problems and face a great risk of massive default.

The other message the two officials wanted to deliver is that policymakers won't define shadow banking by the form of the product but by whether the product is subject to regulation and supervision by authorities.

Authorities' supervision will be the way to handle shadow banking risks, as reflected by Zhou's comment that the government would place effective supervision on shadow banking and Yan's remarks that some wealth management business that is properly regulated is also shadow banking.

But as past experience has shown, authorities were often a step slower in regulating market participants' shadow banking activities, with banks, trust funds, loan companies and other financing vehicles creating new methods to bypass supervision.

In this sense, deregulation is needed to bring shadow banking activities behave themselves.

Although private lending exists for centuries, shadow banking becomes a big problem only in recent years.

Before 2008, the vast majority of lending in China was done through regular banking. The government launched massive stimulus during the global financial crisis, but traditional bank loans cannot help meet the capital demand needed to support the stimulus projects.

Commercial banks thus used many financial tools or innovations that are now classified as shadow banking to provide loans. The main tools or innovations are wealth management products, loans through trust companies, entrusted loans, inter-bank repurchase agreements and bank guarantees.

To some degree, shadow banking played a role of bridging the money market, bond market and credit market. It did cater for the market need and helped create a multilayer financing market, but it also faces the possibility of running away given their high leverage ratio and big risk appetite.

It is more important for authorities to push for deregulations by efforts such as liberalizing interest rates and allowing private capital to enter the banking industry more freely. By doing so, the dual-interest-rate situation will be changed. This means an interest rate gap between regular banks and shadow banking will be narrowed. That will reduce their risk appetite and curb traditionally banks from lending too much to shadow banking players, bringing down the country's overall leverage ratio to a reasonable level.

The author is a Shanghai-based analyst.