may 10th 2014 shadow and substance - the economist€¦ · may 10th 2014 special report...

May 10th 2014

S P E C I A L R E P O R T

I N T E R N AT I O N A L B A N K I N G

Shadow andsubstance

20140510_SRShadowBanking.indd 1 29/04/2014 14:20

The Economist May 10th 2014 1

INTERNATIONAL BANKING

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A list of sources is atEconomist.com/specialreports

An audio interview with the author is atEconomist.com/audiovideo/specialreports

CONTENTS

3 DefinitionsA non-bank by anyother name

4 LendingWe try harder

7 PaymentsThe end of a monopoly

10 TradingSwap you

11 ChinaA question of trust

13 Reshaping thefinancial sectorDo it right

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IT WOULD BE hard to find a company with a greater sense of traditionthan Hall & Woodhouse brewery. Founded in 1777 in the English countyof Dorset, it is still based just a few sheep-speckled hilltops from the vil-lage where it began. It is also still owned and run by descendants of itsfounder, Charles Hall (the Woodhouses married into the family in 1847).It has been brewing on the same site, using water from the same wells,since 1900.

The firm’s grand Victorian brewery complex (pictured), with itsclock tower, turrets and red-brick smokestack, has been preserved withpride. A museum inside displays ancient brewing equipment, a stuffedbadger and sepia-toned pictures of the Halls and Woodhouses of yore,alongside records from Hall & Woodhouse’s earliest days. They show, forexample, that on October 22nd 1779 the firm paid a Mr Snook18 shillingsfor seven quarters (roughly 90kg) of barley. Even the names of the beers,such as “FurstyFerret” and “Blandford Flyer” (said to help ward offthe in-sects that plague local fly-fishermen) are steeped in rural nostalgia.

Until this year the firm’s financial arrangements were equally tradi-tional. It never listed its shares or issued a bond. Instead, whenever itneeded to finance a big new project, such as the gleaming new brewingfacilities that abut��

ictorian ones (now converted to offices), it bor-rowed money from a bank. Given its steady income, its low level of debtand its pristine credit record, it never had any trouble getting a loan, saysMartin Scott, the firm’s finance director.

The financial crisis changed all that. When in 2010 Hall & Wood-house asked its main bank, the Royal BankofScotland (RBS), to renew itsregular £50m ($84m) line of credit, it got a nasty surprise. The manage-ment of RBS had been far less prudent than that of Hall & Woodhouse,

Shadow and substance

As banks retreat in the wake of the financial crisis, “shadowbanks” are taking on a growing share of their business, saysEdward McBride. Will that make finance safer?

ACKNOWLEDGMENT S

Many people helped in the prep-aration of this report. Apart fromthose mentioned in the text,particular thanks are due to Gaël deBoissard, Bob Jain and VanessaNeill, Credit Suisse; Charles Calomi-ris, Columbia University; StephenGreen, Standard Chartered; PaulGurtler, Interlink Maritime; AllisonKellogg, McKinsey; Susan Lund,McKinsey Global Institute; SheriefMeleis and Rick Spitler, Novantas;Michael Poulos and Nick Studer,Oliver Wyman; Richie Prager,BlackRock; Andy Rothman, MatthewsAsia; David Soanes and Rob Baston,UBS; Larry Tabb, Tabb Group; WangYi; and Morgen Zhao, HIT Marine.

2 The Economist May 10th 2014

SPECIAL REPOR TINTERNATIONAL BANKING

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borrowing heavily over the preceding years to expand its busi-ness at breakneck speed. When its own credit dried up, it wasforced to turn to British taxpayers for a £45 billion bail-out andbegan a frantic retrenchment, shedding £1 trillion in assets andcutting its staff by 40,000. The bank told Hall & Woodhouse thatit would renew its line of credit for only three years instead offive, and at a sharply higher rate of interest.

MrScottbalked at thisand arranged a similar loan facility atanother, less troubled bank, but the incident unsettled him andthe owners. They decided they needed more reliable long-termcreditors, so they reduced their bank borrowing and turned in-stead to a shadow bank—a financial firm that is not regulated as abank but performs many of the same functions (see box over-leaf). The one they picked was M&G (the asset-management armof Prudential, a big insurance firm), which offered them £20mover ten years.

Shadow banking got itself a bad name during the financialcrisis, chiefly in the form of off-balance-sheet vehicles that werenotionally separate from banks but in practice dependent onthem. Their assets were often securitised loans that turned out tobe much riskier and less valuable than expected.

These vehicles were meant to expand credit, and thus bol-ster the economy, while spreading the risks involved; at least thatwas the justification for excluding them from the banks’ liabil-ities and allowing them to hold relatively little capital to protectagainstpotential losses. Yetwhen theygot into trouble, the banks

had to bail them out on such a scale that many of the banksthemselves then needed bailing out. The vehicles turned out tobe an accounting gimmickdressed up as a service to society.

Worse, they generally relied on short-term funding frommoney markets, another form of shadow banking. Money-mar-ket funds, in which businesses, institutions and individuals in-vest spare cash for short periods, involved a different sort of sub-terfuge. Although all lending is inherently risky, they presentedthemselves as risk-free. Their shares were supposed to retain asteady value of $1, so when one of the biggest funds announced

at the peak of the crisis that it would haveto “break the buck”, panic ensued.

The flight from the money marketsadded to the troubles of banks and otherfinancial institutions that relied on themfor short-term borrowing. They had madebig losses, were struggling to borrow andso found themselves unable to repay de-positors, bondholders and other creditors.That left taxpayers on the hook, both be-cause governments in most rich countriesguarantee small bank deposits and be-cause they were reluctant to let big banksfail, for fear that the financial system mightfall apart altogether.

Banks have since had their room formanoeuvre severely restricted to makethem safer. New accounting rules havemade it much harder for them to park sus-pect assets in off-balance-sheet vehicles.In effect, lending by banks must be la-

belled as such. And they are now obliged to hold much morecapital to help absorb losses in case another crisis strikes.

There are only three ways for them to increase capital rela-tive to their loans and other assets: by raising more of it, by cut-ting costs or by trimming lending and investment. Banks aroundthe world have been doing all three for several years, to the dis-mayoffirmssuch asHall & Woodhouse. Theyhave an especiallystrong incentive to curb long-term loans to business, since regu-lators not only require them to hold more capital against thembut also to fund long-term loans in part with long-term borrow-ing, which is more expensive than the fly-by-night sort.

As a result, banklending to businesses in America is still 6%below its 2008 high. In the euro zone, where it peaked in 2009, ithas declined by 11%. In Britain it has plummeted by almost 30%.

Bank lending to consumers has shrunk byless, in part because most of it consists ofmortgages, which take some time to unwind(see chart 1). But all in all, big Western bankshave shrunk their balance-sheets by trillionsofdollars.

This retreat of the banks has allowedthe shadow banking system to fill the ensu-ing void. Mr Scott of Hall & Woodhouse, forone, is happy to be able to borrow fromsomewhere other than a bank. Although hisarrangement with M&G is slightly more ex-pensive and less flexible than the shorter-term credit he is still getting from the banks,he says it costs far less in terms of managers’time and allows the firm to plan for the lon-ger term. British banks, he says, simply do notoffer ten-year loans to firms like his any morebecause they cannot make a profit on them.

M&G has no such concerns because it isnot considered a bank, nor regulated as such. The money it hasdoled out to Hall & Woodhouse comesdirectly from institutionalinvestors, including Prudential and various pension funds,which have given M&G £500m to lend to mid-sized British busi-nesses. All the proceeds from the loans go to the investors, whomust also bear any losses; M&G simply administers the portfolioof loans on their behalf and charges them a fee. Whereas a bankintermediates between savers and borrowers by entering intoseparate transactions with each, with all the risk that entails,M&G is merely a matchmaker, with no “skin in the game”.

Hall & Woodhouse needed more reliablelong-term creditors, so it reduced its bankborrowing and turned to a shadow bank



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For all their residual worries about shadow banking, regu-lators like this arrangement, because in some ways it makes thefinancial system safer. If the economy stumbles, causing cor-porate earnings to slide and thus increasing the number of de-faults on loans such as Hall & Woodhouse’s, any losses will fallsquarely on the institutional investors who put up the money.

It is not just M&G that has benefited from the banks’ re-trenchment. The business of “direct lending” or “private debt”(by analogy with private equity) is booming. Investment fundsthatmake loansofthis sort raised $97 billion lastyearworldwideand hope to raise a further$105 billion thisyear, accordingto Priv-ate Debt Investor, a magazine. Another similar but exclusivelyAmerican category, businessdevelopmentcompanies, grew ten-fold between 2003 and 2013, according to the Securities and Ex-change Commission. At the end of last year they held assets—mainly loans to businesses—ofroughly $63 billion.

Don’t bank on it

And private debt is only one form of lending that takesplace outside banks. Bond markets—by far the biggest source ofnon-bank financing—continue to grow even as bank lendingshrinks. In 2007 the value of all outstanding corporate bonds is-sued byAmerican firmswas justunder29% ofGDP; by lastyear ithad risen to over 42%, according to McKinsey. In South Korea thefigure rose even more dramatically, from 23% of GDP to 48%.Globally, corporate bond-issuance doubled between 2007 and2012, to $1.7 trillion, as firms everywhere took advantage of ex-traordinarily low interest rates.

Money markets in the rich world seized up during the crisisand have not yet fully recovered, but in China and other emerg-

ing markets they are growing rapidly. A money-market fundlaunched last June by Alibaba, a Chinese e-commerce giant, at-tracted 500 billion yuan ($81billion) in its first nine months.

Peer-to-peer (P2P) lenders—websites that match saverswith borrowers—are also growing like topsy, albeit from a tinybase. The value of loans chaperoned by Lending Club, the big-gest such website, has doubled every year since its launch in2007 and now totals over $4 billion. New firms are springing upthe world over to cater to all manner of niches, from short-termloans for property developers to advances against unpaid cor-porate invoices.

The Financial Stability Board (FSB), a global financialwatchdog, reckons that shadow lending in all its forms accountsfor roughly a quarter of all financial assets, compared withabout half in the banking system. But it excludes insurance andpension funds from its calculations; add those in, and shadowbanking is almost on a par with the better-lit sort.

According to the FSB, shadow lending has grown by leapsand bounds in recent years. The watchdog estimates that suchloans in the 20 big economies that it tracks rose from $26 trillionin 2002 to $71 trillion in 2012 (see chart 1, previous page). TheFSB’s data show bank lending growing at much the same pace,but that is partly because, in the teeth of the crisis, regulatorsforced financiers trying to game the system to reclassify muchshadow lendingas banklending. The FSB’s data confirm that thesorts of shadow lending that worry regulators, particularly off-balance-sheet vehicles, have atrophied, whereas the sorts thatplease them, including direct lending, have rocketed.

The process of shifting lending out of the banks and intootherfinancial institutions has longbeen underway in America,

THE DEFINITION OF shadow banking is itselfshadowy. The term was coined in 2007 byPaul McCulley, a senior executive at PIMCO, abig asset manager, to describe the legalstructures used by big Western banks beforethe financial crisis to keep opaque and com-plicated securitised loans off their balance-sheets, but it is now generally used muchmore broadly. The Financial Stability Board,an international watchdog set up to guardagainst financial crises, defines shadowbanking as “credit intermediation involvingentities and activities outside the regularbanking system”—in other words, lending byanything other than a bank.

In most countries, only banks can holddeposits guaranteed by the state, and onlybanks have a standing offer of credit from thecentral bank. With these privileges come lotsof rules and restrictions. That is becausebanks, although essential to the smoothoperation of an economy, are vulnerable toruns, which in turn can cause recessions.

However, money can be moved fromsavers to borrowers in many ways that do notinvolve banks. People and companies can

make loans to one another directly, forinstance. A firm might borrow from thou-sands of savers, their money pooled by thebond markets. Or a pension scheme mightput some of its money in an investment fundthat lends to mid-sized businesses.

Most academics and central bankersuse the term “shadow banking” narrowly, forforms of lending that closely resemble bank-ing. The idea is to identify and restrict thesort of behaviour that might lead to futurecrises. One focus is leverage, the amount aninstitution has borrowed relative to theamount of loss-absorbing equity its ownershave put into it. Most investment funds (withthe notable but small exception of hedgefunds) have minimal leverage or none at all,so if they run into trouble there is little riskthat other lenders will suffer as a result. Alas,such contamination was a much biggerproblem for the shadowy vehicles that issuedasset-backed securities before the crisis.

Another concern is any disparity be-tween the time scale of a financial institu-tion’s borrowing and lending (called a matu-rity mismatch if you think it is worrying and

maturity transformation if you think it ishelpful). Just like banks, investment fundsmay struggle to sell loans or call them in if alltheir investors want their money at once.Regulators are trying to limit mismatches atbanks by requiring them to hold more long-term deposits if they issue long-term loans.That logic applies even more strongly to shad-ow banks, in that they do not, at least intheory, have central banks to fall back on inthe event of a run. Most troubling of all isanything that resembles a deposit, in that itcan be reclaimed at will and in full.

Bankers—and this special report—talkabout shadow banking in a much more sweep-ing way, to refer to any financial institutionsthat banks see encroaching on their business.Such competition is most evident in lending,but payments and trading are also affected byit. Some of these competitors are simply banksby another name, trying to boost profits bycutting regulatory corners, which is a worry.But most are genuinely different creatures,able to absorb losses more easily than banks.They are a buttress rather than a threat tofinancial stability.

A non-bank by any other name

Shadow banks are easier to define by what they are not than by what they are

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IN AN ENORMOUS shed on the banks of the Yangtze, Chi-na’s longest river, a remote-controlled blowtorch cuts

through a thick sheet of steel. A fountain of sparks spatters out-wards, watched by workers in hard hats. The machine slowlycarves out a crescent of metal about a metre across. Oncequenched and cooled, it ispiled up on the floorwith hundreds ofother steel shapes, ready for assembly.

The army of welders at the other end of the shed have toshout to be heard above the whine and crackle of their torches.They will gradually assemble the individual pieces into compli-cated lattices. When these grow big enough to weigh 150 tonnes,they will be moved from the shed by a crane and welded to oth-ers on the wharf outside. When these components reach 600tonnes, an even bigger crane will lift them into an adjacent drydock. About a year from now the piles of steel cut-outs will haveturned into the Interlink Fidelity, a ship 180m long and 32m wide,capable ofcarrying 38,800 tonnes ofgrain or iron ore.

There is nothing unusual about this process, except how itis being paid for: with money put up by Carlyle, a private-equityfirm that is branching out into private debt as well. Before the fi-nancial crisis banks accounted for 87% of shipbuilding loans, ac-cording to Marine Money International, a firm that tracks the in-dustry (the rest was financed by bonds). European lenders wereespecially prominent.

Lending

We try harder

Without the banks’ baggage, shadow banks find iteasier to oblige customers

where bond and money markets are well-developed; banksthere now account for only a quarter of loans. But it is also gath-ering pace in Europe, where banks have been especially hard hitby the crisis, and in other parts of the world.

And lending is just one area in which banks find them-selves on the backfoot. The same combination ofstricter regula-tion and increased competition is hurting banks in other areasthat used to be seen as an integral part of their business, such aspayments, the mundane but important business of transferringmoney from one account to another.

The most common and lucrative way for payments to bemade in the rich world is through credit or debit cards. Regula-tors in America and the European Union have been putting lim-its on the fees banks can charge for such transactions. At thesame time all sorts of new payment technologies are springingup, from “virtual wallets” that claim to make the physical sort re-dundant to Bitcoin, a scandal-prone electronic currency thatnonetheless has the potential to turn the business of sendingmoney upside down, cuttingbanks out ofthe process altogether.

New ways to pay

The trading of bonds and other financial instruments—themainstay of investment banking—is another area where banksare pulling back in the face of new technology, new rivals andnew regulatory constraints. Rules that bar or deter banks fromtrading on their own account, and make it more costly to do it forothers by increasing capital requirements, have already resultedin a big drop in the volume of bonds held by investment banks.Other regulations now being introduced are pushing the tradingof derivatives onto public exchanges, greatly reducing banks’ in-fluence over the business and the profits they can make from it.Regulators are also discouraging banks from dealing in physicalcommodities in any form.

Other financial institutions are cheerfully abetting the reg-ulators’ drive to wrest a lot trading from banks. The banks’ bigcustomers—chiefly asset managers of various kinds—are tryingto create systems to trade more among themselves, cutting outthe middlemen. The shift away from fast-talking salesmen to-wards electronic trading is also bolstering exchanges, technol-ogy firms and data providers at the banks’ expense.

Similarly, asset management (which this report will notcover in detail) has been growing much faster outside the bank-ingsystem than within it in recentdecades. The crisis acceleratedthe trend, as some banks sold their asset-management arms toraise money. Regulation designed to protect investors from con-flicts of interest makes it hard for a big bank to do business withan in-house asset-manager, reducing the opportunities for sav-ings or cross-selling. And new technology is making it easier forfirms and individuals to find and invest in a range offinancial in-struments without the help of a bank. The world’s biggest assetmanager, BlackRock, with about $4 trillion under management,is now considerably larger than the biggest bank, the Industrialand Commercial Bank of China, with assets of roughly $3 tril-lion. Before the crisis the reverse was true.

This does not mean that banks are about to fade away; onlythat their relative weight in the financial system is diminishingas other financial institutions proliferate and grow. Indeed, thatis largely what regulators intend. They want to see banks shrinkand welcome the transfer of risky assets to other parts of the fi-nancial system. This special report will chart some of that transi-tion and consider the potential pitfalls.

Whatever the consequences, however, this new world ishere to stay. As Mr Scott of Hall & Woodhouse says of shadowlenders like M&G: “The banks are going to have all their best cus-tomers taken by these people.” 7



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When markets plunged, however, it became apparent thatshippingfirmshad been orderingnewvesselson wildlyoptimis-tic assumptions about the growth in world trade. Yards contin-ued to turn out ships already under construction, adding to theoversupply. Buyers tried to delay or cancel their purchases, andnew orders dried up almost completely. Although freight vol-umes soon began to rise again, the glut kept growing and the val-ue ofships continued to fall.

By then banks had grown leery of the business. Many hadhad to write offmuch oftheirpre-crisis lending to shippingfirms,and revised capital and liquidity rules had made it relatively ex-pensive to keep loans to shipowners (or any other form of long-term lending) on the books. Newbanklendingto the shipping in-dustry fell from $92 billion in 2007 to $33 billion in 2009, accord-ing to Dealogic, a data firm (see chart 2). Even banks with thefunds and the inclination to lend were prepared to put up per-haps only 50% of the cost of a ship rather than the 70% commonbefore the crisis. By 2012 some Chinese shipyards were sitting to-tally idle, says Li Sheng ofHIT Marine, a Chinese shipbroker.

As banks retrenched, private-equity firms such as ApolloGlobal Management, Blackstone, the Carlyle Group and KKR

sawan opportunity in the lowvaluationsofexistingships and inthe shipyards begging for work. Some bought up portfolios ofloans to shipping firms that banks were selling off. Last Decem-ber, for instance, Oaktree Capital Management purchased€280m of shipping loans from Commerzbank, a struggling Ger-man lender that has decided to get out ofshipping altogether.

Others raised money to lend to or invest in shipping firmsor ships. KKR, in conjunction with other investors, has set aside$580m to lend to shipping firms. Carlyle, via an investment in aBermudian shipowner called Interlink Maritime, has ordered 28dry-bulk carriers like the Fidelity. In a separate venture with anAmerican shipping firm and an Asian investment house, it hasput up $750m to buy various container ships.

The shipping industryhasbeen raisingmoneywhere it can,

says Campbell Houston of Marine Money, the shipping-infor-mation firm. Increasingly, that has meant relying on sources oth-er than banks. In 2012 shipowners issued lots of bonds; last yearsaw a spurt of share offerings. Data are scarce, but Mr Houstonguesses that private equity ploughed $30 billion into the indus-try last year (chart 2 shows only publicly announced deals).

“We are deliberately expanding into areas where banks areretreating,” says David Marchick of Carlyle, the private-equityfirm behind the Fidelity. He mentions loans to firms in the energyand commodities business as another promising field wherebanks are pulling back. When Carlyle recently started soundingout investors about a fund to lend to mid-sized oil drillers, refin-eries, power stations and the like, it was hoping to raise $1billion.But insurance companies, pension funds and sovereign-wealthfunds are desperate to earn higher returns than those offered bythe bond market, says Mr Marchick, so demand far outstrippedCarlyle’s target. In the end it limited the fund to $1.4 billion, al-though “co-investment” by some of its big clients will bring totallending to $2 billion. Mr Marchick has many similar tales. “It’s ahuge opportunity,” he concludes.

Bennett Goodman of GSO, the private-debt arm of Black-stone, another big asset manager, takes the same view: “We’re inyear four or five ofa 20-year run.” He predicts that GSO’s lendingwill grow by10-20% a year over the next decade.

Find the market niche

It is not just borrowers from the rich world, and the manu-facturers with which they place orders, that are taking advantageof this trend. David Creighton ofCordiant, which manages morethan $2.4 billion in private-debt funds that lend exclusively tofirms in the developing world, says poor and middle-incomecountries are just as much in need of alternative sources of fi-nance as rich ones. He cites Fiagril, a Brazilian agribusiness towhich Cordiant has just lent $100m. Private enterprises find ithard to obtain a loan ofthat size from local banks, he says, but thesum is too small to justify the expense and hassle of issuing abond. Debt funds like Cordiant’s provide a welcome alternative.

Cordiant has lent to almost 200 firms in more than 50 coun-tries since 2001. At first it worked only with international finan-cial institutions such as the World Bank, which helped reassureinvestors. But it is gradually developing methods to protect lend-ers and thus attract capital more easily.

The banks’ retrenchment since the financial crisis has alsogiven a boost to small-scale operators such as loan sharks, pay-day lenders, pawnbrokers and the like. The value of paydayloans in Britain, for example, more than doubled between 2010

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and 2012, to almost £800m.More importantly, it has en-couraged a new form of grass-roots finance: peer-to-peer(P2P) lending. This involvesmatchingborrowerswith lend-ers through some sort ofonlinesystem. Lenders earn a higherrate of interest than they canget on a bank deposit and bor-rowers often pay less than theywould for a loan from anothersource. The P2P companymakes money by levying a fee,usually a small percentage ofthe money lent. Everyone getsto feel good.

The mostcommon P2P of-fering is an unsecured personal loan, often to refinance credit-card debt. But P2P platforms also offer unsecured loans to busi-nesses, as well as loans on property or against unpaid invoices,student loans and so on. Some allow investors to choose whichloans they underwrite, others bundle them. Some offer insur-ance against defaults, others pass losses directly to investors.

The scale of P2P is still modest: the two biggest Americanoutfits have lent only $5 billion between them, a minute share ofAmerica’s personal-loan market of $1.8 trillion. But the rate ofgrowth is startling. At the smallerofthe two, Prosper, the value ofnew loans agreed in March—$77m—was more than four timesthat a yearearlier. Its lendinghas grown by 3,000% in eight years.Such galloping expansion is commonplace in the industry. De-faults, for the time being, are low.

Even so, bankers often express scepticism about P2P’s stay-ing power. As volumes grow, they say, underwriting standardsare bound to fall. Investors will have no real sense of the risksthey are running until the next downturn arrives. Moreover, themodel’s appeal relies partly on the current low interest ratesaround the world, which make the extra yield from P2P especial-ly alluring to investors. When rates begin to rise again, that ad-vantage will dissipate.

P2P firms retort that it is banks that are living on borrowedtime. Their expensive branch networks and outdated technol-ogy saddle them with far higher costs than those of P2P firms.P2P’s cheerleaders also insist that the industry’s underwritingstandards are just as good as banks’, ifnot better, in part thanks totheirnimbler systems and more creative use ofdata. That shouldallow them to offer better deals while preserving their margins,whatever the prevailing interest rates. These advantages, arguesPartel Tombergof isePankur, an Estonian P2P firm, will allow P2P

to wrest the consumer-lending business from banks over time.“Bit by bit,” he says, “the traditional universal banking model isbeing eaten up by different competitors.”

There are plenty of believers. Google last year led a $125minvestment in Lending Club, the biggest American platform.Two-thirds of the money it lends now comes from hard-headedinstitutional investors. “There is a real risk that banks stop beingthe primary source for personal and small-business loans,”wrote analysts at BBVA, a Spanish bank, last year.

The same debate is taking place about shadow lending as awhole. Moneymen outside banks see their firms’ expansiononto the banks’ turf as a thoroughly good thing. They point outthat shadow banks do not take deposits, in the sense of moneyheld purely for safekeeping, and so cannot lose them in ill-con-ceived ventures. The extent to which they can leverage their in-vestment by borrowing is usually strictly controlled, so the po-

tential for cascading defaults is limited. The borrowing ofAmerica’sbusinessdevelopmentcorporations, for instance, can-not exceed their capital. A move to double the limit is mired inCongress. In contrast, before the crisis big banks had assets of upto 50 times their capital.

The institutional investors that account for the overwhelm-ing majority of shadow lending are sophisticated financial oper-ators with diversified portfolios. The same could not be said ofall bankdepositors. “Ourfund can go to zero,” saysone bigcredit-fund manager, “and none of our investors would be that im-paired.” They often agree to hand over their money for a fixedterm, so there is little chance of a sudden and destabilising surgein withdrawals. If a deal does sour, the losses are passed directlyto the lenders concerned without infecting other transactions.

For the moment P2P loans, credit funds, money marketsand even the bond market have a long way to grow before theyget anywhere near the scale of the world’s banking system (seechart 3). “We would not even be a small division at JPMorgan orBarclays,” says Mr Marchick of Carlyle, which has $189 billion ofassets under management. Or as another shadow banker puts it,“We’re not even a pimple on the bottoms of the big banks.”

Yet their small scale suggests enormous room for growth.Borrowers certainly seem pleased to have more financing op-tions. Yu Wei ofTaizhou Kouan shipyard, where the Fidelity is be-ing built, has nothing but praise for the private-equity firms thathave entered the shipping business. They helped keep the ship-yard afloat at the nadir of the business cycle, he says. That is pre-cisely the point, argues Mr Li of HIT Marine: whereas conven-tional shipowners treasure their ships as they would theirdaughters, private-equity firms treat theirs as an asset like anyother, to be bought when prices are low and sold when they arehigh. So private equityshould help to smooth out the investmentcycle—and a less volatile industry should benefit all participants.

Between two stools

Robert Hartshorne, who writes musical scores for televi-sion shows, is equally delighted by his experience with FundingCircle, a British P2P lender. He is working on an idea for an ani-mated children’s television series based on the animals of theChinese zodiac. A Chinese buyer is lined up, and China’s cultureministryhasgiven itsblessing. ButfirstMrHartshorne has to pro-vide a pilot episode. He and his partner initially financed theventure with £300,000 of their own savings, but when moneyran short he did the rounds of the British high-street banks to askfora loan of£60,000. Despite his successful trackrecord in the in-dustry and the steady stream of royalties he earns, they allturned him down. “It was like sitting opposite a dalek with ashort circuit,” he says. The junior loan officers he met were all be-fuddled by the proposal, yet the sum requested was not bigenough to merit attention from the higher-ups. With FundingCircle, he was able to raise the money within three weeks. Hewill never bother applying for a loan from a bankagain, he says.

Even so, there are natural limits to the growth of shadowlending. For one thing, big institutional investors are a cautiouslot. Allocations from their portfolios to “alternative invest-ments”—the category that covers most shadow loans—remainsmall. In principle, there is a natural fit between long-term inves-tors such as pension funds or insurance firms and the sort oflong-term loans that borrowers are increasingly seeking from theshadow banking system. The premium that lenders can earn onsuch loans has risen as banks have backed away from them,points out Mr Goodman of GSO��et most underwriting exper-tise remains within the banks, notes John Fitzpatrick of the Ge-neva Association, an insurance-industry think-tank. Much as thesovereign-wealth funds and pension giants of the world would



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THE SELF-SERVICE tills at Home Depot, an Americanhome-improvement store, offer customers an unexpected

paymentoption alongside cardsand cash: PayPal, an online-pay-ments service that is trying to muscle into the offline sort. Userssimply enter their phone number and a personal code; electron-ic magic takes care of the rest. Money is deducted from the user’sPayPal account and a receipt with details of the transaction issent to their e-mail address. Purses orwal-lets do not come into it.

In several countries customers atStarbucksdo notneed to reach forcards orcash either. Coffee in hand, they can openthe firm’s app on their mobile phones,hold up a barcode for the cashier to scanand the job is done. Rewards for frequentcustom are automatically tallied up intheir online account.

An even more hands-off paymentoption in many shops in America in-volves a firm called Square. Among otherthings, it offers a “virtual” wallet thatstores details of a user’s credit cards andloyalty-scheme memberships and can beaccessed via a mobile phone. To buythings with it, a customer does not even

need to touch the phone—justhave it with him. Square’s appcan be instructed to turn itselfon and “check in” when theuser enters a store in the firm’snetwork; when he wants to pay,all he has to do is to tell the cash-ier his name and that he is usingSquare. Signatures, PIN num-bers, cards and barcodes are alldone away with. Instead, thecashier’s system brings up a pic-ture of the account-holder, tomake sure he is who he claimsto be, and Square sends him atext message confirming hispurchase to make sure the char-ges are correct.

The world ofpayments is changing: people are buying evermore things online and increasingly with their phones. Whizz-bang technology can make transactions effortless or embedthem seamlessly into other activities, such as booking a cab orsearching for a nearby coffee shop. The numbers are becomingsignificant: PayPal has 143m active accounts and handled $180billion in payments last year. And new services to make spend-ing money easier are springing up all the time.

They are not confined to the rich world: in Kenya roughly60% ofadults—about the same number as have a bankaccount—use a mobile-phone payment service called M-PESA (see chart 4)And increasingly they cater to business customers too: servicesthat integrate electronic invoicing and payments into a firm’sprocurement and accounting system, or that help manage andraise working capital, are becoming commonplace.

Not surprisingly, the titans of the internet have started toeye up the payments business. Google offers a virtual wallet;Amazon recently set up a service to allow its customers to trans-fer money; Facebook and Apple have expressed interest in thefield. There is much speculation that the latest iPhone’s ability toread fingerprints may be heralding a world-changing paymentservice. Telecoms companies (such as Safaricom, the firm be-hind M-PESA) and bricks-and-mortar merchants (Starbucks) arealso dabbling in the field.

Yet banks are largely absent from this technological andcommercial battleground. Payments are a huge business forthem, bringing in $1.3 trillion in 2012, or34% oftheirglobal profits,according to McKinsey, a consultancy. And these revenues havebeen growing steadily: by 3% a year in 2008-12, compared with

Payments

The end of a monopoly

And no end of new ways to pay your bills

Squaremakes iteasier andcheaper forsmallmerchantsto acceptcredit cards

like to earn higher returns, they do not have the capacity to eval-uate the creditworthiness of the businesses that might providethem. Nor, for the most part, do their asset managers.

In time thatmaychange. Butuntil then, assetmanagers willprobablyhave to relyon banks to help generate loans for them topurchase. Unfortunately that idea has a chequered history: dur-ing the financial crisis many of the loans that banks securitisedand sold proved toxic. Securitisation has since shrivelled, andmuch of the remaining amount is created solely for the purposeof lending to central banks, rather than sold.

Regulators are keen to revive securitisation, though theynow require the originating firm to retain some exposure to pre-vent lending standards from slipping. Banks will have to co-ordi-nate with asset managers to ensure they offer the sorts of loansthe asset managers want to invest in, instead of trying to dazzlethem with clever financial engineering.

A partnership between Société Générale and Axa, respec-tively a French bank and an insurer, shows how this might bedone. The pair are lending jointly to mid-sized French firms. So-ciété Générale helps to find the borrowers, manyofwhich are al-ready its clients, and assesses the risk of lending to them; Axaprovides the bulk of the funds. The arrangement works well forSociété Générale, which is able to maintain its relationship withthe borrowing firm without having to put up a lot of capital forthe loan, and it allows Axa to piggyback on Société Générale’swealth of corporate customers. But this sort of co-operation re-quires banks to maintain their ties with businesses in more basicforms ofbanking—which is by no means a sure thing. 7

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just 1% a year for other income. As in their lending businesses,however, banks are finding that new regulations eat into theirrevenue from payments. The main target has been interchangefees, as banks’ charges for processing credit- and debit-card pay-ments are known. The European Parliament recently adopted alaw that would cap these at 0.2% of the value ofa transaction fordebit cards and 0.3% for credit cards. In America the Dodd-Frankact of2010 curbed interchange fees for debit cards.

The American authorities have also extracted big settle-ments from several card issuers for inveigling customers intobuyingexpensive and unnecessaryancillaryservices, such as in-surance against missed card payments. A similar scandal hascost banks dear in Britain. In many jurisdictions the credit-cardnetworks have been investigated by competition authorities.

All this isa worryforbanksbecause credit cardsaccount fora big share of their revenue from payments—41% in North Ameri-ca, according to McKinsey, although less elsewhere. And theiruse is growing fast, especially in booming emerging markets. InChina McKinsey expects it to increase by 42% a year between2012 and 2017. Brazil is already the world’s second-biggest marketfor card transactions after the United States, according to Cap-gemini, another consultancy.

At the same time the wealth of new services is threateningto disrupt the payments business. A few upstarts—most notablyBitcoin, a troubled virtual currency—are seekingto bypass the ex-isting payments infrastructure altogether. Bitcoin has proved avolatile store of value (see chart 5), but as a cheap, reliable andtransparent way to make a transfer it is a notable success.

For the most part, however, the challenge is not head-on. Infact, by making it easier to buy things, most new payments ser-vices are pushing extra business to the existing channels, domin-ated by banks. When a consumer buys something using PayPal,he must still find a way to settle hisPayPal account. That typicallyinvolveseithera card paymentora direct transfer from a bankac-count. Equally, customers at Starbucks top up their loyalty-cardbalances or online accounts by conventional methods. Square isperhaps the best example of this symbiosis: its clever mobilewallet is merely an offshoot of its main business, which makes iteasier and cheaper for small merchants to accept credit cards. Ithas been so successful that it has spawned a host of imitators, in-cluding a European service called iZettle and an offering fromPayPal called PayPal Here, all ofwhich are now pushing millionsofpayments though the credit-card networks.

Nonetheless, such services can nibble away at banks’ rev-enues. In some countries PayPal steers users towards bank trans-fers rather than card transactions by charging lower fees forthem. Such transfers are much cheaper for PayPal (and thus notnearly so lucrative for banks); they cost only a small fixedamount rather than a percentage of the payment. Moreover,when users add funds to their PayPal account in one go to covermore than one purchase, they cut down on the number of bank-mediated transactions.

Perhaps more important, banks are losing out on the infor-mation that comes with handling customers’ purchases directlyand can then be used to steer advertising or provide other ser-vices. An American mobile-payments start-up called LevelUp,for instance, considers that opportunity so valuable that it offersmerchants a discount on the interchange fees that it pays tobanks on theirbehalf. In exchange, the merchants give LevelUp ashare of the money customers spend using promotions deliv-ered through LevelUp’s platform.

Consultants like to speak of “purchasing journeys” inwhich settling the bill is only the final step. Other waystations in-clude advertising, internet search, participation in loyaltyschemes and so on. Innovators, the thinkinggoes, could afford to

undercut market prices for payments in anticipation of greaterrewards at some other stage in the journey. “I could see Googlerunning the payments business,” says Lee Kyriacou ofNovantas,a consultancy. “Advertising could pay for the whole network.”

Tech firms are not the only potential usurpers. Retailers,too, are understandably eager to increase their leverage in theworld ofpayments. In America an alliance ofhousehold names,including Walmart, CVS and ExxonMobil, is in the process of set-ting up a mobile-payments scheme called Merchant CustomerExchange. Such firms may well use their clout to get the banks toreduce their charges on card transactions.

Many telecoms firms, too, see the growth of mobile pay-ments as their chance to break into a lucrative new business.AT&T, T-Mobile an��erizon, three ofAmerica’s four biggest mo-bile providers, have formed a consortium called Isis to developtheir own mobile-payments system and virtual wallet. Similaroutfits have sprung up in many other countries.

In the long run, banks risk becoming the providers of acheap, commoditised service, with most of the money in thepayments business going to firms that make customers’ lives eas-ier or provide new services. As Capgemini put it in a recent re-port: “The payments-acquisition value chain is splitting—withtransactional components becoming commoditised and cus-tomer-engagement components becoming differentiators.”

A good example of this sort of thing is a firm called Simple.It blends online and mobile banking with tools to help custom-ers organise their finances through an elegant website and app.Customers can easily check not only their balance but also theamount that it is safe to spend, taking into account pending billsand recurring payments. They can set goals for savings and bud-gets for different categories of expenditure each month. Simpletracks their progress and can answer questions like “How muchdid I spend on clothes last year?”

Cherchez la banque

The most striking thing about Simple is that it is not a bank.As its website notes, “the funds in your Simple account are heldby our partner bank, The Bancorp Bank, Member FDIC.” Theseaccounts generate revenue in the normal way: from the spreadbetween the interest they earn when lent out and the interestSimple pays on them, and from interchange fees from cards tiedto the account. Simple provides the interface and in return splitsthe revenue with Bancorp. But customers learn the name of thebankwhere their money is held only if they read the fine print.

Even worse for banks would be a future in which peoplebegin to store more of their money outside the banking sectorand make payments thatare not tied to a formal bankaccount. In



2 Simple, the banks seem to play a secondary role.One of M-PESA’s advertisements shows a herdsman in tra-

ditional dress, surrounded by milling cows and goats, smiling ashe reads a text message with an update on the credit in his ac-count. Then a Sikh overseer on a building site realises he canmake his life much simpler by paying his workers via M-PESA in-stead of in cash. Next, a businessman on a plane reaches for hisphone to payhis son’s school fees. The idea beingrammed homeis that M-PESA caters to all Kenyans, irrespective of their income.

Tomorrow the world

Vodafone, Safaricom’s parent, has rolled out M-PESA in sev-eral other African countries as well as in Afghanistan and India.In March it announced it would offer the service in Romania,where more than one-third of the population does not have abankaccount. It says other countries in Europe will follow.

Banks are not ignoring these developments. They aresprucing up their websites and mobile apps and trying to devel-op catchy products of their own. Barclays, a big British bank,signed up 2.5m users for its mobile money-transfer service, Ping-It, in its first 18 months. Erste Group of Austria has developed asystem called Erste Confirming that allows businesses to haggleover invoices, securing discounts for buyers and cheap loansagainst unpaid bills for suppliers.

If necessary, banks can always buy the technology theyneed or the companies that create it. BBVA, a Spanish bank, re-cently bought Simple for $117m—a heady amount for a servicewith just100,000 customers, buta trifle fora buyerwith a marketcapitalisation of€50 billion. And an American subsidiaryof RBS

has teamed up with Bottomline Technologies, a firm that helpsbusinesses pay each other electronically, to beef up its corporateoffering. But acquiring such businesses from the people who in-vented them will not turn the banks into bold innovators. 7

Kenya’s handy alternative to cash

a small way that is already happening in the rich world. Custom-ers offirms such as Starbucks and Shell keep billions in the firms’prepaid cards. “Open-loop” prepaid cards, which can be used atany retailer that accepts card payments, are also becoming morepopular. Transaction volumes have been growing by 20% a year,according to Capgemini. Mercator Advisory Group, yet anotherconsultancy, expects funds loaded onto such cards in Americaalone to reach $80 billion this year.

The issuers of the vast majority of prepaid cards are notbanks; indeed the cards are often explicitly promoted as alterna-tives to a bank account. They usually allow holders to depositcheques, make and receive electronic payments and use cashmachines. Big American retailers, including Walmart and Wal-greens, are getting involved in the business, promoting prepaidcards through their shops and allowing customers to depositmoney at their tills and withdraw it from cash machines on thepremises. In addition to this marketing clout, prepaid cards holda regulatory advantage in America: they are not subject to the in-terchange-fee restrictions that apply to debit cards.

The threat to banks from novel payments systems is evenclearer in poorer countries, since a smaller share of the popula-tion is using a bank in the first place. MasterCard, for instance, isco-operating with the Nigerian government to issue nationalidentity cards that can double as prepaid cards, in a deliberate ef-fort to provide financial services to those withoutbank accounts.�

isa ishelping to develop a mobile-payments system in Rwanda.When such schemes take off, they can quickly supplant

banks as the main local conduit for money. Some 43% of Kenya’sGDP is channelled through M-PESA each year, according to Safa-ricom. M-PESA itselfcannotoffer interest-bearingaccounts, loansor insurance but provides them through tie-ups with several lo-cal banks. The products concerned are available only to M-PESA

customers and can be accessed only via a mobile phone. As with

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TRADING DERIVATIVES—CONTRACTS whose value fluc-tuates with the price of an underlying asset—is a vast busi-

ness. Most are sold “over the counter” (OTC), meaning by directagreement between the two parties rather than through an ex-change. According to the Bank for International Settlements, thenotional value of all OTC derivatives contracts outstanding is al-most $700 trillion. The business is also resilient: it has continuedto grow despite the financial crisis (see chart 6). All of whichmust make it especially galling for bank-ers that regulators want to take the busi-ness away from them.

One counterparty in an OTC con-tract is typically an investment bank; theother a bank or firm seeking to hedgesome sort of risk—a jump in interest rates,for instance. The two might agree on aswap, whereby one promises to pay theother the interest on a bond with a fixedrate in exchange for the interest on a float-ing-rate bond. Since the potential move-ment in the price of the underlying asset(in this instance, the floating-rate bond) isoften theoretically limitless, so are the po-tential losses for one of the two parties.

That is why derivatives have playedsuch a big role in so many financial scan-dals. They were behind the collapse of Barings, a venerable Brit-ish investment bank, in 1995. They helped a trader nicknamed“the London whale” lose $6 billion for JPMorgan Chase, anAmerican bank, in 2012. And they were in large part responsiblefor the collapse of AIG, a big insurance firm that had amassedhuge numbers of credit-default swaps. These deals soured dur-ing the financial crisis, requiring AIG to post unaffordableamounts ofcollateral.

Not all derivatives are sold “over the counter”; there are lotsof exchanges dealing in commodity futures and options, for ex-ample. These tend not to cause such bank-breaking losses, be-

cause trades are public and prices transparent, participants mustpost relatively high margins as a protection against tradinglosses, and trades are carried out through clearing houses, ensur-ing that they are completed even ifone of the parties defaults.

In 2009 the governments of the G20, a club of the world’sbiggest economies, resolved to standardise the most commonsorts ofOTC derivatives contracts, such as interest-rate swaps, sothat they could be traded on exchanges and processed by clear-inghouses. Deals were to be recorded in a central registry, and ro-bust margins posted. The intention was to guard against default,improve transparency, keep down prices and allow regulators tomonitor risk.

It has taken time to implement this plan, but the new rulesare now coming into force. Since February 15th two parties inAmerica have no longer been able to enter into the most com-mon forms of interest-rate swap directly. Instead, they mustchannel their transaction through a “swap execution facility”(SEF)—a watered-down version of an exchange where requestsforswapsare put to multiple bidders—and complete it via a clear-ing house. So far, only the simplest and most common swapshave to be traded in SEFs, but the regulators’ intention is to deep-en the market over time.

Moving derivatives-trading onto exchanges does not cutbanksoutofthe business, butbymakingpricesmore transparentit reduces their profit margins. Moreover, some of the value ofany trade will now go to the SEF and clearing house in fees. Andthe more stringent collateral requirements will make the busi-ness more capital-intensive.

OTC derivatives are only the most striking example of theregulators’ determination to rein in banks’ trading businesses.America has banned banks entirely from speculative trading ontheirown account, a stricture known as��olckerrule; other ju-risdictions have heavily curtailed such activity. The Federal Re-serve is also considering barring banks from trading in physicalcommodities (as opposed to derivatives tied to commodities).

In principle, banksare still free to “make markets” bysellingstocks, bonds and the like to their customers, but new capitalrules have made it harder for them to hold big stockpiles of cor-porate bonds and other volatile financial instruments. First,banks must use a much more conservative formula than previ-ously to estimate the “value at risk” from any given holding. Sec-ond, they have to hold more capital against each dollar at risk—sometimes six or seven times more than before the crisis, say ag-grieved bankers. And third, they have to observe a new limit ontheir overall leverage (the ratio of capital to assets). That makes itless attractive to hold swaps, as both the swap itself and any off-setting hedge add to a bank’s leverage, even though the hedgeserves to reduce risk.

At the same time the profits from bond-broking are beingcompressed as trading moves away from adrenaline-drivensalesmen on phones and onto electronic platforms. Trading inshares went the same way a long time ago; currencies and com-modities have gradually followed suit. The volume of trades hasrisen steeply but the margins have become much thinner.

As a result, banks have cut back on their bond-trading. Be-fore the crisis, “primary dealers”—mainly the big investmentbanks—held bondsworth some $250 billion, or roughly4% ofthe

Trading

Swap you

Hobbled banks are a diminishing presence infinancial markets

Banks’ revenues from ”fixed income”—bonds,commodities, currencies and derivatives—have fallen byabout 40% from their peak in 2009



1

THE NARROW VALLEYS snaking through the arid hillsaround Liulin, a city in Shanxi province in central China,

are pockmarked with coalmines. At each bend in the road a newone heaves into view, announced by the giant conveyor beltsand hoppers for loading. Miners with lamps on their heads, sur-vival kits strapped to their waists and blacksmudges across theirfaces sit by the side of the road, lighting up their first cigarettesafter long hours underground. A thin pall of dust covers everysurface, leaving the roadside shrubs more grey than green.

Until recently these were all signs of prosperity. Mining isso central to the area’s economy that the poshest hotel in town iscalled the Grand Hotel Coal. It occupies part ofa swanky new of-fice complex called Coal Plaza. All around it huge apartmentblocks are under construction, owned, their hoardings proudlydeclare, by coalmining groups.

But coal is no longer showering riches on Liulin. The coalprice has fallen by almost half since 2008. A few mines havebeen abandoned: a squatter has moved into an empty office atone. A few miles up the road two stray dogs lie across the drive-way of a deserted coal-processing plant. It has been shut sinceDecember, says a dishevelled custodian.

The Zhuang Shang mine, just minutes from the centre ofLi-ulin, is still working. It was clearly built with a degree of prideand ambition. A digital display at the entrance to the mine keepstrack of how many workers are inside and how much coal theyhave accumulated in the mine’s storage bins. The miners ridingoutofthe shafton a contraption resemblinga ski lift, with bicycleseats dangling from poles, do not seem bothered about themine’s financial strength. Coal prices are down dramatically, butthat is someone else’s problem. They are still being paid, and ifthings were to get so bad that the mine’s parent, Liansheng

China

A question of trust

Or not, as the case may be

American market, according tothe Federal Reserve Bank ofNework. Now they hold only$50 billion. And because thebond market has grown in themeantime, their shareamounts to only 0.5% of themarket, the lowest proportionthat has ever been recorded.

All this has led to a calam-itous decline in revenues from“fixed income”—the parts of in-vestment banks that deal inbonds, commodities, curren-cies and derivatives. They havefallen to about half their peak(see chart 7), and Morgan Stan-ley, an investment bank, and

OliverWyman, a consultancy, estimate that they will shrink by afurther 5-10% this year.

As with lending and payments, various other financial in-stitutions are trying to capitalise on the restrictions placed onbanks’ trading operations. Commodity-trading firms, for exam-ple, have cheerfully snapped up banks’ unwanted commoditiesbusinesses. In March Mercuria, a Swiss firm, agreed to buyJPMorgan Chase’s physical-commodities unit for $3.5 billion.Such outfits are also expanding their presence in commodity de-rivatives as banks cut staffand close trading desks.

Business is also flowing to exchanges and other tradingplatforms, as well as to the clearing houses that serve them andto the data firms that monitor trading activity. Such firms havebeen growing much faster than the banks themselves, notes TedMoynihan of Oliver Wyman. Indeed, eight of these institutionshave become so big thatAmerican regulatorshave labelled them“systemically important”—not so far behind the number ofAmerican banks (17) that have earned the same label.

Who needs banks?

The banks’ customersare applyingtheirown squeeze by at-tempting to cut them out ofcertain trading activities. Most big as-set-management firms have already taken the first step, which isto “internalise” complementary orders from their differentfunds. If one bit of the firm is selling10-year Treasury bonds andanother is buying, it makes no sense to conduct two separate, ex-pensive transactions with a bank; instead, the firm will simplytransfer the assets internally at market prices.

The next step is for “buy-side” firms to trade with one an-other, without the banks as intermediaries. BlackRock, theworld’s biggest asset manager, attempted something of that sortwith a trading platform it set up in 2012. It did not win much cus-tom, but BlackRockhas not given up: it has folded its trading plat-form into another one belonging to a firm called MarketAxess.

How far can such efforts go? Banks, as underwriters ofnewbond issues, control the distribution ofassets that buy-side firmsare keen to get hold of, so asset managers do not want to alienatethem. And bankers argue that when markets are falling, the buy-side uniformly wants to sell, so banks or other market-makersare needed to provide a price. The buy-side retorts that duringthecrisis banks were just as unwilling as everyone else to get on thewrong side of the market. Now their reluctance to hold much in-ventory gets in the way or their market-making. With time, opti-mists hope, hedge funds, high-frequency traders and other spec-ulators might supplant banks as market-makers.

Irrespective of who does the buying and selling, it is notclear how quickly bond-trading will become electronic. After all,

most listed firms have only one share price, but have typically is-sued dozens of bonds, of differing maturities and at differentrates, sometimes in several currencies and jurisdictions. Thatmakes the market in individual bonds much less liquid: in 2012only1% ofAmerican corporate bonds traded every day.

But even if change takes time, the evolution under way isclearly altering the banks’ role. They will less often be principals,risking money of their own on a trade, and more often agents,linking buyers and sellers together. At the same time the marginsto be earned from trading are likely to come down.

Even so, it will still be possible for investment banks tomake money. “I’m notafraid ofanyofit,” says the head oftradingat one of them. Admittedly banks will need to spend more onsoftware and boffins and less on high-octane salesmen. But suchchangesgenerallypush up volumes, he notes, pavingthe wayfornew products. Thus the birth of the euro eliminated trading in itsvarious precursors, but created a market so large and liquid thattrading in euro options soon tookoff.

The prospect ofselling new-fangled products may be a con-solation, but lower trading margins, in effect, represent a transferof profits from banks to the buy-side—not something for thebanks to celebrate. 7

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Group, could no longer afford their wages, they are sure the gov-ernment would step in and make up the shortfall.

Lots of people, it turns out, have been pinning similarhopes on Liansheng Group. Loans it took out are the only back-ing for a security that a shadow-banking firm called Jilin Trustsold to Chinese investors. Theyploughed 1billion yuan into it, at-tracted by its projected annual yield ofalmost10%. There was noformal guarantee that the investment would provide that sort ofreturn, nor even that the principal would be repaid. But the pro-duct had an air of respectability, having been sold through theChina Construction Bank, the country’s second-biggest lenderand, like almost all Chinese banks, state-owned. Defaults havebeen relatively rare in recent years, and when they have oc-curred, investors have often been compensated.

In a string of announcements starting in December, how-ever, Jilin Trust announced that Liansheng Group would not beable to pay the intereston the loans. Acourt in Liulin said that thegroup had applied to have debts of 30 billion yuan restructured.That process is now underway, leaving investors in limbo.

Market forces

China’s capital markets have been shaken by a series ofsimilar events in recent months. In January another shadowbank, China Credit Trust, announced that a product throughwhich it had raised 3 billion yuan, China Credit Equals Gold #1,was on the verge of default. It, too, was based exclusively onloans to a coalmining group operating in Liulin county, ZhenfuEnergy, and had also been distributed by a reputable firm, the In-dustrial and Commercial Bank of China—the country’s largest

bank. In March a solar-panel manufacturer named Chaorimissed a payment on a bond it had issued, the first such defaultin recent history. Shortly afterwards Li Keqiang, China’s primeminister, said further defaults were inevitable, in keeping withthe Communist Party’s pledge last year to give the markets a “de-cisive” role in allocating capital.

That is an alarming prospect for many. Overall lending inChina has grown at a breakneck pace in recent years (see chart 8on the next page), though precise numbers are hard to come by.The central bank put the total at the end of last year at about200% ofGDP, but its figures, confusingly, include a small amountof share issuance. Standard Chartered, a bank, using a more re-fined measure that includes various forms of borrowing left outby the central bank, such as loans from foreign sources, but ex-cludes equity, has come up with a figure of 231% of GDP, includ-ing foreign debts.

Not unexpectedly, the fastest-growing source of credit hasbeen China’s shadow-banking system. Again, estimates of itssize vary, in part because there is no agreement on what forms oflending should be included. But financial institutions other thanbanks accounted for almost half of credit growth in China lastyear. Most concerns focus on one particular sort of financial in-stitution: trusts, the source of Liansheng and Zhenfu Energy’sloans, which swelled from 3 trillion yuan at the end of2010 to al-most11 trillion (roughly 20% ofGDP) at the end of last year.

Trusts have grown very quickly in part because the centralbankhas limited banks’ lending to parts ofthe economy where itsaw signs of overinvestment, including coalmining and proper-ty. Firms developing mines or apartment complexes often had

Fading black magic

The coalprice hasfallen byalmost halfsince 2008.A few mineshave beenabandoned



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fewotherplaces to turn to. At the same time the central bankcapsinterest on deposits, severely crimping Chinese savers’ return ontheir nest-eggs. Straightforward savings accounts produce nomore than 0.35% a year and a one-year fixed deposit earns atmost 3.3%. That makes trust products, with advertised yields ofaround 10%, enormously alluring.

Liansheng Group and Zhenfu Energy are unlikely to be thetrust sector’s only struggling borrowers. Trusts have lent moneyto lots of other mining firms. Property, another wobbly industry,accounts for perhaps10% of total trust lending, and local govern-ments, many ofwhich have borrowed to invest in overblown in-frastructure projects, for an even bigger share. At the same timegrowth in China’s economy is slowing: the past two years’ 7.7%annual rise was the lowest since 1999. Banks’ write-offs of baddebt, although still tiny at about 1% of lending, have doubled inthe past year.

The Armageddon scenario

Some observers have concluded from all this that China ison the verge of a “Lehman moment”. Increases in a country’sdebton the scale ofChina’shave almostalwaysended in a finan-cial crisis of some sort. A series of defaults in the trust sector, thetheoryruns, will cause investors to lose faith in high-yield invest-ment products. That, in turn, will cause short-term lending to dryup, leaving mid-sized banks with smaller deposit bases strug-gling to finance themselves and making it impossible to roll overtrust loans that fall due this year. More defaults will follow.

Those who predict such an outcome reckon that China’strust sector in many respects resembles pre-crisis shadow bank-ing in the West. Much ofit looks like a blatantattempt byChinesebanks to get around the restrictions regulators have placed onthem. Trust companies are often mere custodians of investmentproducts dreamt up by banks. They raise money by offeringmore attractive returns than banks and lend to sectors banks arenot supposed to. Manyoftheirofferingsare designed to mature aday or two before the end of each quarter, so that the money in-vested in them is returned to customers’ bank accounts just intime to shore up the banks’ loan-to-deposit ratios. Althoughbankshave no formal responsibility ifthe investments sour, theymay end up stepping in to help, as many of their Western coun-terparts did during the financial crisis.

More worrying still, until recently there was a dangerousmismatch between the maturities of trust products (often just acouple of months) and the loans underpinning them (often acouple ofyears). The trust companiesgot round thisby maintain-inga pool ofloansfunded byseveral trustproducts. When one ofthe products matured, they simply raised another one of thesame size. Although these arrangements were not quite Ponzi

schemes, in that the products were backed by real, revenue-gen-eratingassets, theywere almostas fragile. Withoutnew depositsrolling in, the system would have collapsed.

ButChinese financial regulators, like theircolleagues in theWest, have learned some lessons from the events of 2007-08.Last year they banned the pooling trick, requiring each trust pro-duct to be tied to a discrete set of loans. They have also restrictedbanks’ off-balance-sheet activities, often disguised as trusts,which they can do fairly easily because they regulate trust firmsdirectly. That has helped them to maintain lending standards:most trust loans are backed by high levels of collateral andbarred from borrowing to leverage their investments. Anotherrule limits to 35% the share of the money raised by trusts that canbe lent out, as opposed to invested in stocks and bonds. Andonly the rich are allowed to invest in trust products.

The main reason why a calamitous run on Chinese shad-ow banks is unlikely, however, is that the country has the capaci-ty to absorb lots of non-performing loans. Its debts, both shad-owy and well-lit, are much smaller relative to GDP than theywere in most Western countries before the crisis struck. Moreimportant, China’s central government and the big state-ownedbanks are still in rude financial health and could intervene tobuy up troubled assets, preventing the credit market from seiz-ing up. Currency controls would stop panicked Chinese fromspiriting their money out of the country.

The fate of China Credit Equals Gold, the troubled trustproduct based on loans to Zhenfu Energy, is instructive. Days be-fore the threatened default a mystery buyer suddenly appearedand acquired some of Zhenfu Energy’s assets. That allowed allthe principal to be repaid; in the end, investors lost only a por-tion of their last interest payment. Although the details remainopaque, most observers assume that China Credit Trust, ICBC

and the provincial and central governments worked together toavoid a more destabilising outcome. The authorities and theiragents could afford to repeat that on a much grander scale. 7

“WE ARE GOING to have tough global competitors,” saidJamie Dimon, the boss of JPMorgan Chase, the world’s sec-

ond-largest bank by value, in a letter to shareholders earlier thisyear. One of the main sources of competition, he went on to ex-plain, would be shadow banks:

We really should not call them “shadow” banks—they do not operatein shadows. They are non-bank financial competitors, and there is awide set of them. They range from money-market funds and assetmanagers, mortgage real-estate investment trusts and mortgage ser-vicers and middle-market lending funds to PayPal and clearinghouses. Many of these institutions are smart and sophisticated andwill benefit as banks move out ofcertain products and services. Non-bankfinancial competitors will lookat every product we price, and ifthey can do it cheaper with their set ofcapital providers, they will.

Needless to say, Mr Dimon believes that JPMorgan Chasewill continue to be a big and successful business. But it is operat-ing in a changing environment, where boundaries are blurringand banks, with their stricter capital requirements, will not nec-

Reshaping the financial sector

Do it right

Shadow banking can reduce risk, but only if failure isan option

SPECIAL REPOR T

(which allowed them to escapewith onlyminimal losses) is thatthe authorities, although keen topreserve the idea that trust in-vestments carry risk, were evenkeener to avoid a panic.

They succeeded in that,but not in chastening Chineseinvestors. Savers continue topile into products that offerhigher returns than bank ac-counts. Hence the dramaticgrowth of Alibaba’s money-market fund. Some confusionabout risk is understandable. Intheory, the Chinese governmentdoes not guarantee any finan-cial products, not even small re-tail deposits (although it haspromised to introduce depositinsurance later this year). Inpractice, it seems to underwritealmost everything.

The experience in Westerncountries since the financial cri-sis has not been that different.Although on paper most gov-ernments offer no guaranteesexcept on retail deposits up to acertain size, they have bailed outnot only banks and their off-bal-ance-sheet vehicles but insur-ance firms, broker-dealers, car-finance companies and money-market funds, among other shadow-banking entities. Severalcentral banks have bought up asset-backed securities, the basiccurrency ofshadow banking. In America the SEC is still trying todecide whether money-market funds can advertise themselvesas having a stable value, thus appearing never to lose money.

Introducing extra competition across a range of businessescan only be a boon to consumers, spurring banks to improve

their services and giving their customersmore options. It will also reverse the con-centration of risk within the banks. Butnew risks will arise in other places—andthe growth of shadow lending and the in-creasing presence offinancial institutionsother than banks in fields such as pay-ments and trading will only make it moretempting to provide a backstop for shad-ow banks.

Ifa ruinous share of the losses in thenext recession is passed to pensionersand holders of life-insurance policiesthrough the shadow-bankingsystem, willthe authorities just shrug? If hackersmake off with people’s hard-earned sav-ings by infiltrating a big prepaid-card net-work, will regulators point to the fineprint of the deposit-insurance rules? Andif bond or derivative markets dominatedby asset managers and speculators seizeup, will central banks feel an obligation toprovide extra liquidity? Politicians andvoters will have to decide—and prefera-bly before the next crisis. 7



Business in Asia May 31stPoland June 21stCyber-security July 12thMedia and technology September 13th

2 essarily have a clear advantage over their non-bank rivals. Heeven identifies certain activities that he thinks banks will strug-gle to maintain, including the provision of revolving credit facil-ities such as Hall & Woodhouse used to enjoy at RBS; the holdingof certain big, short-term corporate deposits; and the trading ofderivatives. “There is nothing inherently wrong with this,” hesays. “It is a natural state of affairs and, in some cases, may bene-fit the clients who get the better price.”

That is not the only benefit, however. Regulators are en-couraging the growth of certain types of shadow bank not to re-duce the cost offinancial services—though that is a worthy goal—but to make the financial system safer. Shadow banking can dothat by disseminating risk beyond the banks. It increases thepool of possible lenders and reduces the likelihood that defaultswill cascade through the financial system, leading to a crisis ofconfidence. That, in turn, will help widen access to credit—to thebenefit ofboth individuals and the economy as a whole.

These desirable effects will depend on preventing a resur-gence of the forms ofshadow banking that caused so much trou-ble in the crisis. Shadow banks should not make long-term loansusing fleeting deposits, as banks sometimes do. Nor should theybe allowed to borrow so heavily from banks that a failure amongthem might infect the banking system. They certainly should notbe, in essence, disguised appendages of banks, as many were inthe West and some still are in China.

The benefits of failure

By and large, regulators understand these principles andare moving that way. Yet even once rules to that effect have beenfully implemented, it is important to understand that shadowbanking does not reduce the likelihood ofdefaults on individualloans—it just transfers the losses to parts of the financial systemwhere they are less likely to have nasty repercussions. In otherwords, investors will still suffer from time to time, even if the sys-tem is working as intended.

In this respect regulators in China, and in the West too, aremakinga worryinghash of things, in the name of the very stabil-ity that shadow banking is supposed to bolster. The surprisinglast-minute rescue of investors in Zhenfu Energy is a case inpoint. The most widely accepted interpretation of the deal

Less of this

may 10th 2014 shadow and substance - the economist€¦ · may 10th 2014 special report...

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