China shadow bank curbs attack symptom not cause

March 28, 2013

By John Foley

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)

China is getting tough on shadow banks, but not on the causes of shadow banking. New rules will force mainstream lenders to cap their exposure to some of the riskier off-balance sheet products they have sold to customers – in particular, those that are effectively repackaged corporate debt. That limits a big source of risk for banks, but creates a new one for the Chinese economy.

The new regulations target wealth management products: short-term investments generally distributed by banks but that mostly don’t sit on their balance sheets. At the end of 2012, there were 7.1 trillion yuan ($1.1 trillion) of these products outstanding. Of these, 80 percent didn’t appear on banks’ balance sheets, and 80 percent of those were invested in corporate credit such as loans, according to Standard & Poor’s. That’s equivalent to around 4 percent of Chinese banks’ assets – bang on the new limit prescribed by the China Banking Regulatory Commission.

Capping credit-backed products is good for the banking system. Even though most wealth management products aren’t explicitly guaranteed, many investors expect the bank to return their cash. So the new rules limit banks’ exposure if loans go bad. True, this will be painful for smaller lenders which have used the products to circumvent loan quotas and generate fees. China Minsheng, whose shares fell 8 percent on March 28, made 8 percent of its operating income from such products in the first half of 2012.

Yet even if banks are protected, the causes of China’s shadow banking boom persist. The cap on official deposit rates pushes savers towards products that promise a higher yield. Loan quotas mean some private borrowers can’t borrow from banks or the bond market, forcing them to seek alternative sources of funding.

Cutting down on off-balance sheet lending will just create new problems. Companies may be forced to turn to even more shadowy sources of finance, like loan sharks and ill-regulated private lenders. Alternatively, they will go bust, impacting economic growth. For as long as China’s financial system fails to price deposits and allocate loans properly, chasing shadows will be a fruitless pursuit.

 

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