Shedding Light on Shadow Banking9 min read

Demystifying the commoner’s financier – Mary Davis


Shadow banking has a bad reputation the world over, but particularly in China. Major media outlets and economists alike have demonized it, casting their black mark of economic imbalance across all faux-banking operations throughout the country. But what if they were not the evil shark-loaning, wobbly institutions that we’ve been made to believe? What if they were helpful more than harmful?

This was the opinion of one Chinese banker who left his job as deputy head of Investment Banking at UBS to become a shadow banker in 2011. After moving to the “dark side,” Joe Zhang ended up publishing a book on his experiences, Inside China’s Shadow Banking, in which he described the greater opinion of shadow bankers in China to be “only slightly more respectable than perhaps massage parlors or nightclubs.”

If you’ve ever walked the streets of any city in China, you know the country is full of self-made businessmen and women: from roadside hawkers to florists, to farmers, to fruit harvesters, to restaurateurs. These were Zhang’s clients. They were in need of money to start new business ventures. But their sector, or their background (and lack of any connection to the state), deemed them totally invalid for traditional loans from China’s conventional banks.

Despite the sour social opinion of the shadow banking enterprise, Zhang saw an opportunity to fill a major gap left by the government’s strict lending practices. He opened up a microlending firm in Guangdong Province, offering credit to these small-scale entrepreneurs.

Zhang’s company was just one of many microfinance companies that popped up to offer a quick and easy loan to those who were willing to pay high interest. Borrowers could get up to $20,000 at a time from Zhang’s company at an interest rate of 24% annually, much higher than the average bank rate in China of 4.35%. Most budding entrepreneurs would see that as a rip-off, and yet Zhang said that demand was constantly flowing in. Zhang was easily able to make a large profit, and he never was without customers, because what alternative did they have? Zhang said that close contact with clients allowed the business to remain fairly secure. He maintained a 5% average of borrowers who defaulted, and was thus able to make a steady profit for a few years until he closed the business in 2013 due to frustrations over the industry’s seemingly illogical roadblocks.

Zhang was not a bad guy, and neither were his borrowers. In fact, both sides were taking advantage of a skewed system of financial repression. Not only are state-owned Chinese banks encouraged to focus on offering loans to state-owned companies, they are restricted to offering these loans only to certain sectors. If you want to go into construction and become one of millions building for China’s housing boom, you may be able to get a loan. But if your dream is to open a second-hand jewelry shop in downtown Kunming, you are forced to look for “shadier” methods of securing capital to get your company up and running.

In fact, both sides were taking advantage of a skewed system of financial repression”

So why did shadow banking mushroom in China? The answer is threefold. First, China is getting rich. The middle class population is constantly growing and constantly consuming more, while its über rich are collecting so much money that they cannot find places to invest it and gain a decent return.

Second, banks are a traditional option for safe, long-term investments. However, in China, banks are offering investors such low interest rates on the money they keep in their bank accounts that by the time they withdraw their savings, inflation will have actually decreased the overall value of money. This predicament would push any intelligent investor away from banks and toward more lucrative investment options, such as the stock exchange. Again, outside of China, this would be a great option. Inside, however, it’s a disaster. After several stops and starts and varying efforts to improve the market, both the Shenzhen and Shanghai stock exchanges have offered investors underwhelming dividends at best. This is due to a host of scandals including insider trading and lack of transparency that eventually turned people away, and that gave China’s stock exchanges a reputation as the country’s largest casino.

The real estate market is (or was) a bit better. You’ve either read about or been the direct victim of ballooning house prices across China, so you know that the market value of property has risen swiftly and continually. But even housing investments are becoming increasingly regulated, precisely because so many of China’s wealthy have used it as their main investment mechanism. As a result, the government has restricted housing purchases in several cities across the country in an effort to cool down the ballooning market.

With banks, the stock market, and housing all seen as investment dead ends, rich Chinese began pouring their funds into other international markets (think of wealthy Chinese paying cash for million-dollar homes in Vancouver and Los Angeles). But this too has been increasingly restricted, as the government aims to patch the leaks that channel China’s funds into other markets. China’s domestic investment market (or lack thereof) has driven many of the country’s wealthiest into the arms of shadow banking.  

So what is shadow banking? This dodgy sounding terminology has almost become synonymous with the Chinese economy, and yet the idea was born in the US and is in fact much more present there. The term “shadow bank” was coined a decade ago by the owner of a big US bond fund to describe bank-like companies that were created (by banks) to sell less than top-quality loans. It was, and in many instances still is, a way for banks to do things off the books. The modern definition of shadow banking encompasses many more players. It includes an array of financial intermediaries that perform bank-like activities without being regulated as banks, from pawnshops to wealth management products to peer-to-peer lending websites. The lack of regulation is the key factor here: these institutions can lend as if they were banks, but they do not have to follow state rules or mandates that conventional banks do. They promise much higher returns than any other domestic option, but they take on much more risk, which is transferred on to the shoulders of their investors.

China’s domestic investment market (or lack thereof) has driven many of the country’s wealthiest into the arms of shadow banking”

The term “shadow banking” instantly makes these businesses sound like the juvenile delinquents of the finance industry, but in reality they are part and parcel of a burgeoning economy. Both in China and abroad you can enter any microfinance office in broad daylight, borrow funds on peer-to-peer lending sites or pitch your company’s unique idea to any hedge fund that will listen. While these are all categorized as shadow banking entities, none of this is illegal activity, nor is it hiding in the shadows.

In fact, you may not be as far removed from the shadow banking industry as you think. Have you ever used Alipay or WeChat Pay? These Chinese mobile payment apps have aided in more than doubling the Chinese mobile payment volume to $5 trillion in 2016. It’s hard to believe that just three years ago these popular online payment systems were categorized as shadow banking conduits, before being given official bank status by the government in 2015. The state’s decision to grant banking licenses to five private companies was made in an effort to loosen the very financial restrictions that are locking the majority of its citizens out of a piece of the financial pie.

This was a start, but a very small one compared to the demand in China’s market, which is why shadow banking is still alive and well. The market is helping a lot of people who otherwise would have no chance at getting their shot in the growing Chinese economy. In fact, these loaning platforms are some of the very mechanisms that have helped China to become less dependent on its Made in China exports and more focused on increasing the country’s domestic consumption. Increases in domestic travel and in the popularity of Chinese brands over foreign ones are just a few examples of products and services that have gained momentum thanks to capital received from shadow banks.

So why is everyone so worried about China’s shadow banks? Neither international economists nor the Chinese government are afraid of them – shadow banking is present in most major developed economies, on much larger scales than China’s. It is the rate at which shadow banks have proliferated over the past few years that has raised eyebrows. Having been legalized only in 2008, this type of lending has expanded significantly since the start of the decade, and has more than quadrupled in the last few years alone. Interestingly, recent data on the rapid growth of the industry is coming from the state itself, as the current administration is becoming more open about its somewhat off-balance balance sheet.

However, as the government sheds more light on shadow banking, they are also simultaneously taking swift action to clamp down on it. In early December 2017 the government announced a ban on all unlicensed lending and put a cap on the interest rates of microlenders. Regulators will also stop approving new microlenders. This means there is little hope for those who were expecting to make a quick buck like Zhang did, or gain speedy access to big funds as so many business hopefuls do. The government is right to worry, as a large influx of shadow banking operations was one of the main components that sent the US into the Great Recession less than ten years ago. Without the need for shadow banks to adhere to state regulations, the government cannot keep these shape-shifting institutions under its thumb. The larger the shadow market, the less the government can see and understand about its own economy.

Instability is not a noun China would like to have associated with its famous, steadily growing economy. As Xi Jinping’s administration continues to curb excessive leverage and financial instability, it will have to find the sweet spot between securing fiscal safety and smothering growth. For the time being, shadow banks will continue to walk the tightrope in between. ∎


Featured image by “Chris” and used under Creative Commons license.