Chinese Shadow Banking: Risks and Rewards
I had the opportunity to visit one of Shenzhen’s biggest nonprofit business associations several weeks ago with my friend, Jonathan, a fixed income analyst from Singapore. After some formal in-office discussions with the general manager David, we were driven to a seaside coffee house where the three of us chatted about the latest investment trend brewing in China.
From the perspective of a personal friend, David began by asking us if we would be interested in investing in some capital-protection wealth management product with one of the local banks. Upon hearing terms like “capital protection” and “banks,” Jonathan and I wanted to know more.
David obliged. For a minimum subscription of RMB$1 million, the bank would sign a contract with the investor, guaranteeing a fixed return of 8% per annum, with full capital protection and a one- to three-year term. And for a minimum subscription of RMB$3 million, the bank could offer a better deal — a guaranteed fixed return of 10% per annum, with full capital protection and a three-year term.
Naturally, Jonathan and I were relatively skeptical of such good deals. Shrugging his shoulders, David acknowledged our concerns and told us that precisely because the deals are so attractive, they typically get snapped up the moment they are released. And unless one has a very good working relationship with private bankers, it is virtually impossible for retail investors to participate even if they have the money.
He went on to say that for most retail investors, they would have to make do with capital protection products that come with a fixed return of 4% per annum and a one-year term.
When we questioned how the underlying business model worked, David responded: The banks “take the investor’s money, lend it out to corporations, charge them 15% to 18% interest per annum, pay the investor 10% per annum, and pocket the difference.” He went on to explain that if corporations could not pay up, the bank would sell off pledged collateral to fulfill its obligation to investors, and that was how the bank could offer guarantees on both capital protection and fixed-interest payments.
He also shared that regulators have rendered such explicit guarantees to be illegal for fear of systemic risk. The loophole, however, is that the compliance responsibility only rests with the banks while any contract signed between investors and banks is still recognized by the legal system. In short, while it is illegal for banks to offer such explicit guarantee terms, it is completely legal for investors to purchase it. That is why such products are being sold discreetly and only to high net-worth individuals who have close contacts with private bankers, he explained. This is a good example of the adverse impact of a less robust enforcement regime.
It soon became clear to Jonathan and me that what we were hearing was a pitch for one of the bare forms of shadow banking, where on one hand, you have private bankers who are desperate to hit their sales targets, and on the other hand, investors who yearn for high returns with “no risk.” In between the two parties are small and medium enterprises (SMEs) that are finding it hard to get loans at market rates; hungry for cash, they eventually resort to getting bank loans with exorbitantly high interest rates.
Both Jonathan and I zoomed in on the potential landmines for such a business model:
- Value of collateral might drop below par value of loan.
- Full capital protection given by a bank is only as valid as the normal operation of the bank. During an illiquidity crunch, would such protection be upheld?
- If these banks have a wide depository base and can utilize it to fund these lucrative loans, why are they borrowing from investors at an 8% interest rate when they could source it from depositors at less than 1%?
To date, bankruptcy of a bank has never occurred in modern China (since 1949), even though there are a few near-bankruptcy cases being reported by the media. It is widely hypothesized within the industry that regulators are too in awe of the potential systemic risk to let a bank fail. However, regional banks are testing the limits of central regulators through the moral hazard dilemma. In other words, bankers know their balance sheet will be protected regardless; therefore, nothing is going to stop them from structuring risky wealth management products that have huge domestic demand.
It is not known how big and widespread the capital protection products’ hold is within the wealth management product family, but given the fact that banks are offering 8% per annum for investors’ money, they must have exhausted the legal limit on depositors’ money that could be used to finance the lucrative SME loans. Do note that there is a limit in terms of loan diversification where banks’ loan portfolios cannot be overly concentrated in any one particular sector. This regulatory feature makes sure banks are comfortably cushioned during instances of prevalent loan default that originate from a particular sector.
China is on the verge of revamping its bankruptcy law on banks, and only time will tell what the Chinese regulators have up their sleeves. Until that time, a capital protection scheme with 8% guaranteed return is simply too tempting for investors to pass up and seek capital allocation elsewhere.
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