How Does Traditional Banking Work?

To understand shadow banking, we must first know how traditional banking structures operate. In its simplest form, a traditional banking structure begins with businesses needing capital. Business owners seek capital from their banks, who weigh a spectrum of risks to decide whether they will loan the requested capital. If approved, the businesses will be required to repay their loans in full, plus accrued interest. Sticking to the age-old adage of “don’t put all your eggs in one basket,” banks lend out to numerous businesses with the understanding that they won’t all be able to repay their loan. This is an important aspect of traditional bank structures, because banks are required to set aside cash to offset potential losses. This plays a key role in the health and stability of financial institutions.

How Does Shadow Banking Work?

Outside the traditional banking structure exists the role of shadow banking. A shadow bank is a bank or company that packages together a Wealth Management Product (WMP). WMPs can consist of nearly any loan, such as a simple loan to a small business owner, local government project, bridge construction, toll-ways, infrastructure, you name it! Companies and banks will pair these loans with high-yield-like interest rates and offer them to investors. They can also offer WMPs to investment banks who, in turn, repackage and offer to their investors. As you can see, this gets complicated quickly. As WMP complexities rise, the ability to understand the underlying risks of the product are diminished. This rising complexity and the fact that the risks of shadow bank financing is kept in part off the balance sheet is a red flag. Institutions hide the risks involved in shadow banking by booking a new “investment receivables” line item on the balance sheet, which can be a problem, as it can obscure the underlying credit risks and make investments seem much more attractive than they are on paper.

Shadow Banking in China

According to the CLSA, shadow banking occurs in over fifty percent of current financing in China.¹ Most of this lending is from financial institutions who are being creative in their lending practices and circumventing government regulations.

All of these factors raise a red flag when it comes to lending practices in China. China has seen an explosion of growth over the last decade, which has been fueled mainly by credit. As authorities pressured financial institutions to lend more by lowering reserve requirements, demand quickly caught up and the institutions soon didn’t have enough deposits to cover demand. Introduce WMPs and — voilà — no more issues raising cash. Zhou Xiaochuan, the Chinese central bank Governor, has warned that their financial institutions lack both competition and the ability to appropriately price risk. Zhou states, “high leverage is the ultimate origin of macro financial vulnerability,”² which is reflected in the country’s use of excessive debt and the rapid expansion of credit that has outpaced sustainable levels.

Scenario planning governs our risk management philosophy here at SFG. For more on our view on current debt levels around the globe and how we use scenario planning as a risk management tool, read our Market Review & Outlook whitepaper, as well as our Scenario Planning versus Forecasting blog post.

References:

1. Report on total % of shadow banking in China
2. Chinese Central Bank’s President Zhou Xiaochuan commentary on financial risk

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