Spotlight is set to shine on shadow banking

The government is said to be tightening oversight over the rapidly expanding sector

China is tightening its grip on the rapidly expanding shadow banking business. Financial experts applauded the latest regulations and advised the government to take moderate measures in order not to put banks and the real economy under too much pressure while the Chinese economy slows down.

"Banking regulators must make sure they cut the links between formal and informal financial institutions to prevent regional risks from spreading nationwide. During the process, they should be careful not to go too far. Otherwise, the capital chain is likely to break once they over-tighten liquidity," said Lei Wei, a financial researcher with the Development Research Center of the State Council, a top government think tank.

She said the People's Bank of China, the country's central bank, should open up liquidity slightly and lower the yuan deposit reserve ratio while it tightens up on shadow banking.

The China Banking Regulatory Commission has set up a leadership group on banking industry reform headed by its chairman, Shang Fulin.

There were rumors the State Council, China's cabinet, issued a set of guidelines known as Document No 107 to address shadow banking issues in December. If true, this implies that it is a priority for Beijing to keep shadow lending under control and to mitigate the associated risks, according to a research report by HSBC Holdings Plc.

Although the government has not yet confirmed the guidelines were issued, it was widely reported the State Council document cast shadow banking into three major categories. They are: completely unregulated credit intermediaries without a license, including Internet finance companies and third-party wealth management institutions; unlicensed credit intermediaries that lack sufficient regulation, including financing guarantee corporations and micro-loan companies; finally, services provided by licensed financial institutions that lack sufficient regulation or avoid regulation, including money market funds, asset-backed securitization and certain wealth management services.

China's shadow banking sector has grown by leaps and bounds in recent years partly because formal financing channels such as bank loans, bonds and public offerings set the bar too high for fundraising appeals and therefore could not meet the demands of social capital, said Lu Zhengwei, chief economist at Industrial Bank Co Ltd.

The risks of shadow banking have expanded rapidly since 2012 and aroused the intense attention of the State Council.

Statistics released by the PBOC on Jan 15 showed off-balance-sheet financing, including entrusted loans, trust loans and non-discounted bills of exchange, increased by 1.55 trillion yuan ($256 billion) year-on-year to 5.17 trillion yuan in 2013, accounting for nearly 30 percent of total social financing.

At a conservative estimate, China's shadow banking market has reached about 30 trillion yuan, including more than 10 trillion yuan of trust products, 9 trillion yuan of wealth management products and 5 trillion yuan of money market transactions, said Li Jianjun, assistant dean at the School of Finance under the Central University of Finance and Economics.

The government is tightening oversight of shadow banking services as the risks grow. The central bank has strengthened efforts to monitor and assess the risks involved in shadow banking, said Sheng Songcheng, head of the statistics and analysis department of the PBOC, at a recent news briefing.

He said regulatory authorities should guide the shadow banking system toward positive development and monitor potential risks to better serve the sound operation of the financial system and sustainable development of the real economy.

Improved regulations on shadow banking are not intended to halt operations, not least because a large part of shadow lending is playing a positive role in supporting the real economy, said the HSBC report.

It noted that shadow lending is essential for driving investment growth. For instance, 26 percent of China's trust loans financed infrastructure projects and 30 percent of manufacturing and commercial companies.

"We expect Beijing to strike a balance between mitigating risks and stabilizing growth. The expected scale-back of the interbank business and improved regulation of shadow lending will likely moderate the growth of total social financing. But even if total social financing growth slows to around 15 percent in 2014 from around 17 percent in 2013, given that the M2 growth target is likely to be unchanged at 13 percent, growth in gross domestic product of 7.5 percent will likely be supported," wrote HSBC economists Qu Hongbin and Sun Junwei in the report. M2 is the amount of money in circulation in notes and coins plus private banking deposits and funds.

There have been rumors that compared with previous banking regulations, Document No 107 stated clearly that all shadow banking entities will have designated regulatory authorities. For those entities which the relevant regulatory authorities have not yet clarified, the central bank will formulate measures with the relevant government departments.

The State Council's guidelines also called for the standardization of cross-market financial products by clarifying the responsibilities of their fundraising channels and risk bearers.

In the past, different Chinese regulatory authorities applied different regulations to financial products of the same nature. Such unequal regulation prompted some regulators to reduce their supervisory efforts over shadow banking, said a financial expert who declined to be named.

Apart from establishing unified standards, regulators need to create a binding mechanism for financial services that are similar to credit activities but currently fall outside their supervision to reduce the scope for regulatory arbitrage, said Liu Yuhui, an economist with the Institute of Finance and Banking at the Chinese Academy of Social Sciences.

Lei, with the Development Research Center of the State Council, said coordination between the PBOC and relevant regulatory authorities is extremely important.

"We need a higher-level coordination mechanism led by a top leader above the central bank and the three main regulatory commissions of banking, securities and insurance, rather than having the central bank and regulatory commissions launching their own regulations for shadow banking," she said.

Lei suggested lawmakers should update laws concerning financial products in a timely way and create new regulations to clarify the nature and supervision principles of shadow banking.

"As new forms of shadow banking are constantly arising, regulators must design the supervision mechanism accordingly to keep up with the development of shadow banking activities by giving sufficient oversight power to different institutions in the market such as law firms, accounting firms and the media," said Lu of the Industrial Bank Co.