shadow banking in china

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Shadow banking in China: A primer

Douglas Elliott, The Brookings Institution, Economic StudiesArthur Kroeber, The Brookings-Tsinghua CenterYu Qiao, The Brookings-Tsinghua Center

March 2015

The rapid development of Chinas shadow banking sector since 2010 has attracted a great amount ofcommentary both inside and outside the country. Haunted by the severe crisis in the US nancial systemin 2008, which was caused in part by the previously unsuspected fragility of a large network of non-banknancial activities, many analysts wonder if China might be headed for a similar meltdown. The concern isespecially acute given Chinas very rapid rate of credit creation since 2010 and the lack of transparency inmuch off balance sheet or non-bank activity.

This paper will address the following questions:

What is shadow banking?

Why does the sector matter?

What was the Chinese credit system like before shadow banking?

What is the nature of shadow banking in China now?

How big is shadow banking in China? Why has Chinese shadow banking grown so fast?

How does Chinese shadow banking relate to the formal banking sector?

Why has the Chinese sector developed as it has?

How does the size and structure of shadow banking in China compare to other countries?

Will there be a major shadow banking crisis in China?

How do Chinese authorities intend to reform shadow banking?

The authors would like to acknowledge the assistance of a number of experts, including Jason Bedford, DarrellDufe, Stephen Green, Wei Hou, Dinny McMahon, Logan Wright, and Kai Yan. In addition, several reviewers chose toremain anonymous. The authors, of course, are solely responsible for any errors in this paper.


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The Brookings Institution Shadow banking in China 1

Executive Summary

Shadow banks are nancial rms that perform similarfunctions and assume similar risks to banks. Beingoutside the formal banking sector generally means they

lack a strong safety net, such as publicly guaranteeddeposit insurance or lender of last resort facilities fromcentral banks, and operate with a different, and usuallylesser, level of regulatory oversight. These characteristicsincrease the risks for nancial stability, which is the mainreason there is a focus on shadow banks today.

Shadow banks can help spur economic growth by makingnancial services cheaper and more widely available, butthere is usually a trade-off in terms of reduced nancialstability. One reason for the trade-off is that shadowbanks exibility and price competitiveness often comesat the expense of safety margins. Banks, for example,are generally required to have signicantly more capitaland liquidity than shadow banks may choose to carry.Shadow banks are also less regulated. This combinationforces policymakers into difcult balancing acts to try tomaximize the benets while minimizing the risks.

Shadow banking in China must be viewed in the contextof a system which remains dominated by banks,especially large state-controlled banks, and in whichthe state provides a great deal of direction to banks,through a variety of regulations and formal and informalguidance. In the last few years, those constraints havebecome sufciently binding that business has owed toshadow banks.

There are a number of pressures pushing business awayfrom banks towards shadow banks, including the factthat:

There are caps on bank lending volumes imposed bythe Peoples Bank of China (PBOC).

The limit of bank loans to deposits of 75% isconstraining.

Regulators discourage lending to certain industries.

Most non-bank channels have lower capital andliquidity requirements.

Shadow banks are not subject to bank limits on loanor deposit rates.

Shadow banking avoids costly PBOC reserverequirements.

Perhaps two-thirds of the ow of business into shadowbanking is effectively bank loans in disguise, wherea bank is at the core of the transaction and takes thegreat bulk of the risks and rewards, but pays non-banks

to participate in order to avoid regulatory constraintsand costs. The other third or so of the business thathas moved results from a combination of competitive

advantages for the non-banks, many due to looserregulation, and a willingness and ability to reach outto smaller, private sector businesses that are not well-served by the banks.

Shadow banking transactions generally make use of oneor more of the following techniques and instruments:

Loans and leases by trust companies. Trust companiesare nancial rms in China that have a quite exiblecharter and combine elements of banks and assetmanagers.

Entrusted loans. These are loans made on behalf oflarge corporations, using banks or nance companiesas intermediaries. They are most commonly to othercompanies in the same group or to suppliers orcustomers. There is also an interbank version, where onebank will act on behalf of another.

Bankers Acceptances. These are notes issued by banksthat promise to pay a xed amount a few months in thefuture. Generally these are supposed to be issued inconnection with a non-nancial transaction, such as apurchase of goods, but reports suggest they are oftenused more loosely.

Micronance companies. These are separately regulated

nancial rms that are licensed to lend in small amountsto help encourage credit access for small and ruralborrowers.

Financial leasing. This represents leasing of all kinds thatis not already on a bank or trust company balance sheetand is not a short-term operating lease.

Guarantees.Guarantee companies in China providenancial guarantees, including to facilitate shadowbanking transactions. Many guarantee companies havebranched out to make direct loans, even though they donot have legal licenses to do so.

Pawn shops and various unofcial lenders. Pawn shopsare important lenders to some households and smallbusinesses. In addition, there are other types of lendersthat operate informally or even clearly illegally.

Trust Beneciary Rights (TBRs). TBRs are effectivelya simple form of derivative transaction whereby thepurchaser of the TBR receives all or a stated proportionof the returns accruing to a trust. Banks sometimes use


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TBRs as part of complex shadow banking transactions tokeep the economic benets of a loan without showing itas a loan on their balance sheets, but moving it to a morefavorably treated investment category.

Wealth management products. These are investmentproducts that provide a return based on the performanceof a pool of underlying assets. Typically the underlyinginvestment is a single large loan or a pool of loans.WMPs are generally offered by banks or trust companies,although securities rms offer similar products knownas Directional Asset Management Products. WMPs areincluded in discussions of shadow banking in large partbecause they are a close substitute for bank deposits.WMP investors generally assume that the target returnof these products is effectively guaranteed by any bankor trust associated with the product. WMPs are usuallypurchased by relatively wealthy investors as substitutesfor bank deposits, with the benet of higher yields thanbanks are allowed to offer on formal deposits.

Inter-bank market activities. Another substitute forformal deposits is created using the inter-bank market.Despite its name, many participants in this market arenot banks but are large corporations using nancecompany subsidiaries to participate. They can lendmoney to banks in deposit-like arrangements withoutbeing subject to caps on deposit rates and withoutforcing banks to incur many of the regulatory costsof deposits, such as triggering the minimum reserverequirements.

There is a range of estimates of the size of shadowbanking in China, depending on the denition of shadow

banking and estimates of some important statistics. Sixreasonable estimates in the recent past produced guresranging from about RMB 5 trillion to RMB 46 trillion,or roughly 8 to 80 percent of the size of Chinas GrossDomestic Product (GDP). Dr. Yu, one of our co-authors,estimated the size at RMB 25 trillion, or 43% of GDP, in2013. This compares to an estimate from the FinancialStability Board (FSB) that global shadow banking assetswere equivalent to 120% of GDP. On the same basis, theUS was at 150%. Thus, Chinas shadow banking sectoris relatively small compared with advanced economies.Further, it is not especially large in comparison with otheremerging market countries as a percent of national GDP.

Using gures from the PBOCs measure of Total SocialFinance (TSF), shadow banking accounted for about 18%1

1. Calculated as the share of total net flows of TSF accounted for by trustloans, entrusted loans, and undiscounted bankers acceptances. Peoples Bankof China, All-system Financing Aggregate Statistics in 2014, Peoples Bank ofChina News, January, 29, 2015, available at http://www.pbc.gov.cn/publish/en-glish/955/2015/20150129085803713420369/20150129085803713420369_.html.

of net ows of TSF in 2014. Despite the rapid growth ofshadow banking, it remains substantially less importantthan formal banking as a source of credit in China.

One of the key questions is whether China could besubject to a severe crisis in shadow banking and howbad the damage might be in such an event. There iscertainly signicant risk that a crisis could develop inshadow banking, for multiple reasons; among others:the business is inherently riskier than regular bankingand operates with smaller safety margins; China isgoing through some difcult adjustments economicallythat could trigger loan losses; and there is too littletransparency in shadow banking and too much relianceon implicit guarantees.

However, the nancial system and the centralgovernment appear to be well positioned to deal withsuch a crisis. First, shadow banking is small enoughcompared to the size of the total nancial sector to behandled without disaster. Second, most of the shadow

banking is closely enough tied to banks that they arelikely to end up honoring their implicit guarantees anddealing with most of the mess on their own. Third, theauthorities have more than enough scal capacity todeal with even a large shadow banking crisis, given quitelow central government debt to GDP ratios, even whenadjusted for off-balance sheet obligations, such as theneed to rescue some local and regional governments.

If this optimistic view is wrong, it is likely to be becausethe lack of clarity about shadow banking has hiddenlarger problems than appear to exist and also slowsdown and muddies a government response. A possible

contributing factor would be if the anti-corruptioncampaign makes it too hard for authorities to make thenecessary decisions with the information available tothem. The nancial system is much more complicatednow than the last time the government rescued it,when the major banks were completely owned by thegovernment and nancial relationships were simpler allaround. Now there would be questions about how thegovernment chose to allocate costs and benets across amuch wider range of players, many in the private sector.

In sum, Chinas shadow banking sector is not especiallylarge by international standards, is relatively simple (with

low levels of instruments such as securitized assets andderivatives), and is overseen by regulators who haveso far shown themselves alive to the most importantrisks (namely funding risk and lack of transparency) andhave taken prudent steps to minimize these risks. Theauthorities take seriously their mandate to maintainnancial stability, and have acted pre-emptively (forinstance in the inter-bank squeeze of June 2013) to nip inthe bud practices that might threaten that stability.


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The problem for Chinas nancial authorities is that thevery large traditional banking sector is not fully servingthe increasingly complex nancial needs of an economytransitioning from a focus on industry and infrastructureto one based mainly on consumer services and alsomoving from state ownership and control to a greaterlevel of private enterprise.

The balancing act between encouraging shadow banks tosupply needed credit to sectors that are not well servedby traditional banks and at the same time protectingnancial stability and investors is a very difcult one. Acompanion paper will present our recommendations forreforming shadow banking and implementing relatedchanges in the wider nancial sector.


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Shadow banking is not a new phenomenon, but the termonly recently came into widespread use,2and there is nosingle agreed denition. The Financial Stability Board(FSB) broadly describes shadow banking as creditintermediation involving entities and activities outside

the regular banking system3

. The Peoples Bank of China(PBOC) uses a denition of shadow banking that seeksto take the particulars of their own national situationinto full account. They dene Chinas shadow banking[system] as credit intermediation involving entities andactivities outside the regular banking system that servesto provide liquidity and credit transformation andwhich could potentially be a source of systemic riskor regulatory arbitrage.4Some additional denitions ofshadow banking by various researchers are included inAppendix A.

Whatever the precise denition, shadow banks performsimilar functions and assume similar risks to banks,namely those associated with maturity, credit, andliquidity transformation. Being outside the formalbanking sector generally means they lack a strong safetynet, such as publicly guaranteed deposit insurance orlender of last resort facilities from central banks. Theyalso operate with a different, and usually lesser, level ofregulatory oversight. All of these characteristics increasethe risks for nancial stability, which is the main reasonthere is a focus on shadow banks today.

We would like to acknowledge that shadow bankingoften has negative implications and sets banks as theappropriate comparison for institutions that sometimes

share only a few characteristics with banks (for instance,insurers or funds managers). We would prefer to usea more neutral term; however, the phrase has becomeso ingrained in public policy discussions that we feelcompelled to use it in this paper.

All denitions of shadow banking pose practicaldifculties, both in their precise denition and in theirusefulness for describing the real world. For example,it is difcult to draw the line between those institutionsand activities that are guaranteed by the governmentand those that are not. Formal denitions often provedeceptive when a nancial crisis develops. For example,

U.S. investment banks were suddenly swept into thesafety net previously available only to commercialbanks, once the Lehman insolvency occurred. In China,there is no guarantee system for bank deposits, but

2. Paul McCulley, an economist and investment manager at PIMCO, is widelycredited with coining the term in 2007.

3. Financial Stability Board (2013).

4. Peoples Bank of China (2013).

virtually everyone assumed, we believe correctly, thatthe government would in practice protect bank deposits.(Thus, the promised creation of an explicit depositguarantee system may actually reducethe level of publicguarantees, since it will have coverage limits, similar tothose in most nations.)

It is also harder than it may seem to determine if aninstitution is providing a banking-like service, such asmaturity transformation. Life insurers may issue long-term policies, but allow early withdrawal of funds undercertain conditions. Is this sufcient to view them asoffering maturity transformation in a signicant way?

For all of these reasons, varying denitions of shadowbanking can produce quite different estimates of the sizeof that system. Further, shadow banking is more of acatch-all than a category, encompassing a very broadrange of heterogeneous activities ranging from well-established, simple and normally low-risk practices (suchas money market mutual funds) to new, exotic and poorly

understood transactions involving one or more layers ofcomplex derivatives. This can make broad generalizationsabout shadow banks misleading.

Why does the sector matter?

Shadow banking has signicant economic benets andcosts. On the positive side, shadow banks can help fueleconomic growth by making nancial services cheaperand more widely available. They can often operate morecheaply than formal banks and therefore provide lowercost loans and other nancial services. They may also

be able to offer services that banks cannot or cater tocustomers that banks cannot or will not serve.

However, this exibility and price competitiveness oftencomes at the expense of safety margins. Banks, forexample, are generally required to have signicantlymore capital and liquidity than shadow banks maychoose to carry. This can be expensive5, but it makes thebanks safer. Further, shadow banks often lend to riskiercustomers or in riskier forms, such as by foregoingcollateral protection that a bank would require. They alsogenerally operate with much less regulatory supervision,which is designed to curb excessively risky behavior. Asa result of all this, shadow banks tend to be substantiallyless stable than banks. Further, they fall outside thepublic safety nets of deposit guarantees and lender of

5. In the first instance, capital is more expensive than debt and depositsbecause funders demand higher returns to compensate for their greaterrisk from investing in equity and other capital instruments. As described byModigliani and Miller in their classic work, this can be offset by the increasedsafety of a firm that holds more equity. In practice, this is only a partial offset,as described further in Elliott (2013). There is a similar logic with liquidityrequirements.

What is shadow banking?


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last resort facilities that protect banks, so instability atthese institutions can spread and accelerate faster thanwith banks. Panic is more likely to occur in relation toshadow banks and the public mechanisms to halt suchpanics are ad hocin nature and therefore have lessercredibility and more risk of failure.

In sum, shadow banks can help spur economic growth,but usually do so at the expense of nancial stability. Thisforces policymakers into difcult balancing acts to try tomaximize the benets while minimizing the risks.

In Chinas case there is an added factor to the balancingact. The authorities recognize that the nancial sectorneeds to be liberalized with a range of important reformsthat will reduce State control of banking decisions. Theincomplete nature of current reforms leaves banksmuch more constrained than in advanced economies,as described below. This creates many favorableopportunities for non-bank channels to compete withbanks through regulatory arbitrage. In policy circles,

this term is virtually always meant as a strong negative.However, in an over-regulated economy with too largea State role, there can be societal benets from suchregulatory arbitrage. It can diminish the deadweightcosts of inappropriate or excessive regulation and it canhelp force the pace of more comprehensive reforms.

What was the Chinese credit systemlike before shadow banking?

Banks completely dominated Chinas credit systemfrom the start of the era of reform and opening upin 1978 until shadow banking began to take off in the2000s. Even as recently as the end of 2008, banks loansrepresented almost 7/8th of outstanding credit in China.(Those readers interested in a broader overview of theChinese Financial System can see Elliott and Yan (2013)).

Banks inherited a privileged position as reform began inChina, including:

Customer base. Almost all lending under the statecontrolled system was done through banks, giving them ahuge existing customer base, especially with the State-Owned Enterprises (SOEs) that dominated the economy.

Legal protections against competition. There were fewlegal alternatives to bank deposits or bank loans inChinas highly controlled economy.

Implicit guarantees. Banks benetted from a free implicitguarantee on their deposits, since it was inconceivablethat the State would allow any signicant loss fordepositors, despite the lack of formal guarantees. This

safety allowed banks to gather large deposit volumesdespite paying low rates.

Regulatory controls on deposit and loan rates. Banks hadthe advantage of a system of regulatory limits on themaximum deposit rate they could pay and the minimumloan rate they could charge. These were intended in largepart to ensure that they had healthy prot margins.

These major advantages were partially offset by anumber of signicant burdens imposed by the State:

Controls on loan volumes. Chinese monetary policy waslargely run by controlling the volume of bank loans, whichproduced a similar effect to controlling overall moneysupply, given the dominance of the banks. The PBOCset limits for total loan volume by banks in aggregateand these limits were then apportioned out to individualbanks. In recent years this has left banks unable to makethe full volume of loans they would have liked.

Micromanagement of lending. In the initial period of

reform, many bank loans were still made on the basis ofdirection from important government or party ofcials.This type of direction is much rarer now, although it stillappears to happen at smaller banks that are closely tiedto government entities at the regional or local level.However, even the largest banks receive broader-basedinstructions to avoid or limit lending to certain industriesthat the government feels need to shrink, such as coalmining. This may conict with the banks preferredstrategies and may even make it difcult for them tocontinue supporting rms to whom they have existingloans that could be endangered by a sudden pullback ofcredit.

Strict loan to deposit ratios. Banks are not allowed to lendfunds equal to more than 75% of their deposit volumes.Recently, this has been a serious constraint on loangrowth, especially as conventional deposit growth hasslowed sharply in the face of competing products, usuallyfrom the shadow banking realm. Regulators recentlybegan allowing some non-traditional deposits, such asfrom the inter-bank market, to be counted in this gurein order to provide more leeway.

High reserve requirements. Banks are required to holdsubstantial reserves as deposits at the PBOC, earning

rates far below what banks could earn on their normalbusiness and even below their own cost of funds. Thislevel varies, but currently about 19.5%6of deposits must

6. The PBOC cut the required reserve ratio by 50 basis points for most smalland medium sized and rural banks in June 2014. It followed up this looseningin February 2015 by cutting the ratio by 50 basis points for the larger banks aswell. As of February 6, 2015, rural credit cooperatives and small financial insti-tutions face a required reserve ratio of 16.0%, small and medium sized banks17.5%, and large depository institutions 19.5%.


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be placed with the PBOC. This is a considerable economicburden. For instance, an opportunity cost of 3 percentagepoints a year on 20% of deposits would be 0.60% ontotal deposits. Deposits remain the major source ofbank funding, so the reserve requirements represent asubstantial cost in aggregate.

Until recent years, the positives of being a bankoverwhelmed the negatives and helped account for thedominance of banks as credit providers. However, asdescribed in the next section, this balance has swungconsiderably and created large opportunities for shadowbanking.

There were other important features of the credit systemat the beginning of the 2000s and prior:

Bond markets were tiny. Financial markets tend to beimportant providers of funds to large corporations inadvanced economies and China is slowly moving in thisdirection. However, it is only recently that this became

a signicant source of funds for businesses. Even now,much of the bond purchases are made by banks for theirown accounts, overstating the importance of the bondmarkets 15%7share of total credit provision.

Banks were state-owned. Until 20048all of the majorbanks in China were 100% owned by the State. Even now,majority shareholdings give the government effectivecontrol of all major banks. Along with State ownershiphas come a strong role for the Communist Party of China(CPC or Party), particularly in personnel decisions.The top positions at the biggest banks are lled by theOrganization Department of the CPC and those chosenexecutives often move to senior State positions overthe course of their career. This presumably producesa different outlook and set of choices by senior bankexecutives than if they were competing in a free labormarket and focused on private sector careers.

Banks favored SOEs in their lending policies. Banks inChina have a strong tendency to lend to SOEs and thisbias was even greater in the past. SOEs are favored for avariety of reasons, including: implicit State guarantees;favored market positions for some SOEs that makethem better credit risks; internal reward and punishmentsystems that mean a failed loan to an SOE is unlikelyto be punished severely while bad loans to the private

sector can lead to job loss; social/career considerationsthat make lending to entities run by powerful Partymembers attractive; and even direct pressure from

7. Calculated as the proportion of total social financing accounted for by netfinancing of corporate bonds.

8. Starting in 2004, China began transforming the wholly state-owned banksinto joint-stock corporations in a process called equitization. See Martin(2012).

Party or State ofcials. The last factor is of decreasingimportance, but has not vanished.

Conversely, banks failed to fully serve small andmedium-sized enterprises (SMEs) in the private sector.The bias towards SOEs is exacerbated by a clear biasagainst private sector entities, especially SMEs. This isunfortunate, since much of Chinas economic growthhas come from these rms, which are reported to haveprovided 70% of employment and 60% of Chinas GDPin 2012, while receiving only 20% of bank loans9. (Thedisparity may be less than this, although still large.Different sources provide varying gures, partly becausethere is no authoritative denition of SME in China andthe numbers can be quite different depending on whichrms are included, which makes is particularly hard tocompare shares of bank loans with shares of employmentor GDP, for example. Lardy (2014) does a particularlythorough job of trying to capture all SMEs and estimatesthat 36% of total business loans in 2012 went to SMEs10.)

It must be noted that most nations nd it difcult tochannel sufcient credit to SMEs, but this problemis substantially more severe in China because of thestructure of the banking sector and the many incentivesand constraints they face that over-ride pure protconsiderations.

In addition to a specic bias towards SOEs, and thereforeaway from everyone else, there are further reasonsthat banks neglect SMEs. First, SMEs lack high-qualitycollateral and long credit histories and are associatedwith higher risk. This is particularly problematic in abanking system that relies heavily on collateral, as

Chinas does. Second, under the current commercial bankcredit manager responsibility system, the punishment forprivate enterprise loan default is much higher than is thepunishment for SOE loan default11.

There has been some improvement in the abilityand willingness of banks to lend to SMEs, due to acombination of government and market pressures.One analyst argues that this is happening faster thangenerally appreciated, writing in a private communicationthat joint stock banks in particular operate in a semi-liberalized environment by virtue of the fact that theyhistorically played the role of corporate banker and

more and more corporate deposits are appearingas inter-bank deposits where rates are not capped.

9. Sheng (2015). Please note that it is unclear from the report in what year the20% of bank loans figure is for. Some other sources suggest figures closer to30% for SME loans in 2012.

10. See Lardy (2014), Appendix A, particularly Table A.2.

11. For example, in a private communication, Elliott was told that the headof SME lending at one provincial bank has a firm cap of 3% for the level ofnon-performing loans, above which he has been told he would lose his job.


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Consequently, these banks need to achieve risk-efcient returns thereby forcing them to lend to theprivate sector. Similarly, for city and rural commerciallenders they often are locked out of most SOE lendingopportunities and must lend to the private sector. Thesame analyst argues that more and more banks aresetting up specialized risk assessment processes and

procedures for SMEs.Nonetheless, despite progress that has undoubtedly beenmade, even optimistic analysts generally agree that SMEsremain at a considerable disadvantage with banks, overand above those confronted in other countries.

What is the nature of shadowbanking in China now?

As noted at the beginning, there are multiple denitionsof shadow banking, and therefore no consensus on which

activities are included and how large the aggregatevolume is. Typically, the following types of lending orother nancial activities would be included:

Trust loans and leases. Financial transactions undertakenby trust companies, a separately regulated type of rmthat combines elements of banks and fund managers inWestern nancial systems. Trust companies have widelatitude to operate across the nancial sector, althoughregulations are increasingly tightening constraints ontheir activities.

Entrusted loans. These are loans made by rms in thenon-nancial economy that are run through banks for

legal reasons, but with the banks indemnied from thecredit risk of the borrower by the non-nancial rm.Some entrusted loans are funded by SOEs as a wayof proting from their ability to borrow cheaply andin large volume by on-lending the funds they obtain.However, the majority of entrusted loans appear to belent within a corporate group, with HKMA (2014) showing74% of this lending was to subsidiaries and 7% to otherafliates. Lending within a corporate group would not beconsidered shadow banking under standard denitions,but it is difcult to separate this out from loans tounrelated parties. For example, even lending within onegroup in China may still be between entities that are

only loosely connected and where the borrower maybe allowed to fail without the failure of other membersof the group. This analytical problem leads to mostcalculations treating all entrusted loans as shadowbanking, even though this doubtless exaggerates the sizeof shadow banking in China.

Bankers acceptances (BA). These are certicates issuedby banks that promise unconditionally to make a future

payment, usually within 6 months, and are generallybacked in part by a deposit from the party desiring thebankers acceptance to be issued. These are normallyused to back commercial transactions such as purchasesof inventory, where the seller receives a BA obtained bythe purchaser from its bank, generally with a deposit ascollateral. BAs may be sold by the holders at a discount

rate prior to the maturity date, often back to the issuingbank. If not traded in this manner, they are known asundiscounted bankers acceptances. One reason theseinstruments are often included in shadow bankingcalculations is that borrowers can use them as a way oflevering a modest deposit into a large, off-balance sheetloan from a bank. There are even reports of borrowerscreating a spiral whereby they take the BA, obtain a loanbased on the discounted value of the BA, and use thesefunds to make a new deposit to back a further, larger BA.Since BAs can be used as quasi-money, on a discountedbasis, this can create very considerable leverage.Nonetheless, counting all BAs as shadow banking clearly

exaggerates the size of shadow banking on standarddenitions.

Interbank entrusted loan payment. This is a loan that onebank makes to another banks client on the second banksbehalf. As the entrusted payment matures, the rst bankwill receive principal and interest paid by the secondbank.

Micronance companies. These are separately regulatednancial rms that are licensed to lend in small amountsto help encourage credit access for small and ruralborrowers.

Financial leasing.This represents leasing of all kinds thatis not already on a bank or trust company balance sheetand is not a short-term operating lease.

Special purpose nance companies associated withe-commerce. There is an increasing level of activity in thee-commerce realm where SMEs are nanced by afliatesof the e-commerce platforms, such as through Ant, anentity associated with Alibaba.

Guarantees. Guarantee companies in China participatein shadow banking in two ways. First, their core businessof providing nancial guarantees can facilitate shadowbanking transactions by transferring the credit risk to

the guarantee rm, which generally also reduces capitalrequirements for banks making such guaranteed loans.Second, many guarantee companies have branched outto make direct loans, even though they do not have legallicenses to do so.

Pawn shops and unofcial lenders. Pawn shops areimportant lenders to some households and smallbusinesses. In addition, there are other types of lenders


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that operate informally, including relatives, friends,and neighborhood associations. Further, there areillegal lending activities as well. It is difcult to obtaindata on total lending from informal or illegal channels,for obvious reasons, but it is not believed to be a highpercentage of shadow banking.

Bond markets. The corporate bond market is sometimesincluded in calculations of shadow banking volumes, eventhough standard denitions globally would not supportsuch a choice.

Trust Beneciary Rights (TBRs). TBRs are effectivelya simple form of derivative transaction whereby thepurchaser of the TBR receives all or a stated proportionof the returns accruing to a trust. Banks sometimes useTBRs as part of complex shadow banking transactions tokeep the economic benets of a loan without retainingit as a loan on their balance sheets. Instead, it would beshown as an investment with a much lower risk weightfor purposes of calculating required capital and where it

would have no impact on loan to deposit ratios or otherlimits on loan volumes. Owning TBRs that provide 100%of the returns to a trust that owns only a single loan iseconomically equivalent to having made the loan andretained it on the banks balance sheet as a loan, minusany fees to the trust company or other party involvedin the trust holding the loan. However, the regulatoryconstraints and costs can be quite different. Bankregulators in 2014 moved to discourage this particularuse of TBRs.

Wealth management products. These are investmentproducts that provide a return based on the performance

of a pool of underlying assets. Typically the underlyinginvestment was a single large loan or a pool of loans,although WMPs increasingly have at least a small portionof equity in their underlying investments. Regulatorsmoved in 2013 to require that no more than 35% of theassets of new WMPs at each bank be in non-standardproducts, generally those that are not traded onexchanges, which limits the ability to include bank loans.

WMPs are generally offered by banks or trust companies,although securities rms and asset managers offersimilar products under different names and with fewerconstraints that are increasingly used in place of bank

WMPs that face more restrictions. WMPs are includedin discussions of shadow banking in large part becausethey are a close substitute for bank deposits. Anecdotalevidence, and polling results, demonstrate that WMPinvestors strongly assume that the target return of theseproducts is effectively guaranteed by any bank or trustassociated with the product. In practice, sponsors haveapparently rescued a number of failed WMPs, althoughthis has been done with little transparency. WMPs are

generally purchased by relatively wealthy investors,including some salaried professionals, as substitutesfor bank deposits, with the benet of higher yields thanbanks are allowed to offer on formal deposits. Althoughit is reasonable to include WMP in calculations of shadowbanking activity, it is important to avoid double counting,whereby the WMP as a funding source is added to the

underlying loans in the product.Inter-bank market activities. Another substitute forformal deposits is created using the inter-bank market.Despite its name, many participants in this market arenot banks but are large corporations using nancecompany subsidiaries to participate. They can lendmoney to banks in deposit-like arrangements withoutbeing subject to the caps on deposit rates and withoutforcing banks to incur many of the regulatory costsof deposits, such as triggering the minimum reserverequirements. It may not be appropriate to label these asshadow banking activities, but they share characteristics

of WMPs. In addition, other shadow banking activitiesmay benet from using the inter-bank market to facilitatetheir operations, for example, the purchase of TBRs.

How big is shadow bankingin China?

There is a range of estimates from different analysts onthe size of shadow banking in China. Differences stemfrom important variations in the denitions of shadowbanking, worsened by the necessity of estimatingimportant statistics. Table 1 shows six recent estimates of

its size. (Appendix B shows a longer list of estimates withmore details.) As can be seen, the gures range from alow of about RMB 5 trillion to RMB 46 trillion.

One of the co-authors of this paper, Yu Qiao, estimatesthe scale of shadow banking at RMB 25 trillion as ofthe end of 2013, or about 43% of Chinas GDP. This fallsbroadly in the middle of the range of estimates in thetable above. Table 2 (page after next) provides moredetails on his calculations.

Virtually all estimates of the size of shadow bankingin China start with gures provided by the PBOC onthe level of Total Social Financing (TSF). The PBOC

provides these gures for the year 2002 and onwards,in recognition that banks ceased to be the only nancesources that mattered and it became necessary toexamine a fuller range of nancial activity. There aresome idiosyncrasies in these calculations as comparedto standard global calculations of credit volumes. Inparticular, some non-credit nancial activities areincluded, such as equity raising and venture capital.


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It would be better for our purposes to focus solely oncredit, but analysts of China are very accustomed toexamining gures for TSF and the non-credit componentsare relatively small. Therefore we will generally quoteTSF gures without trying to back out the non-creditactivities.

Since shadow banking comprises much of the non-bankTSF activities, it is useful to look at the pattern of growthof TSF. Exhibit 1 shows the level of TSF since 2006,broken down by its principal components.

Exhibit 2 (page after next) shows the same componentsas percentages of TSF.

Finally, Exhibit 3 (also page after next), from IMF (2014b)shows the accumulated stock of credit provided by thedifferent components of TSF.

Why has Chinese shadow bankinggrown so fast?

Although it is difcult to be precise, it appears thatabout two-thirds of shadow banking lending in Chinacan be characterized as bank loans in disguise thatresult from regulatory arbitrage. That is, this portion of

Exhibit 1.

Net Flows of Total Social Financing

Source: Peoples Bank of China / Haver Analytics

Estimate Period RMB (trillion) USD (trillion) % of GDP

IMF March-2014 19.9 3.2 35% of 2014 GDP

UBS YE-2013 28.4 39.8 4.6 6.5 50 70% of 2013 GDP

Standard Chartered YE-2013 4.5 12.5 0.7 2.0 8 22% of 2013 GDP

Bangkok Bank YE-2013 36.4 6.0 70% of 2012 GDP

JP Morgan YE-2013 46 7.5 81.2% of 2013 GDP

Financial StabilityBoard

YE-2013 18.2 3.0 31% of 2013 GDP

Note: Some of the gures have been derived by the authors; for example, if a source only provided an estimate in dollars for a givenperiod, then the authors used exchange rate and GDP gures to estimate the other columns

Table 1.

Estimates of the Size of Chinas Shadow Banking Sector


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Entrustedloans

Trust loansBankers'

acceptances

Interbankentrusted loan

payments

Financialleasing

Small loancompanies

Total

2002 267 0 256 5232003 328 0 457 784

2004 639 0 428 1067

2005 836 0 430 1266

2006 1105 172 580 444 2212

2007 1442 342 1250 558 3503

2008 1868 657 1357 738 4530

2009 2546 1093 1818 628 5995

2010 3421 1480 4152 1680 270 198 111112011 4717 1683 5179 1872 426 391 14180

2012 6001 2972 6229 2894 608 592 19207

2013 8551 4812 7004 3000 766 819 24952

110

2002 267 0 256 523

2003 328 0 457 784

2004 639 0 428 1067

2005 836 0 430 1266

2006 1105 172 580 444 2212

2007 1442 342 1250 558 3503

2008 1868 657 1357 738 4530

2009 2546 1093 1818 628 5995

2010 3421 1480 4152 1680 270 198 11111

2011 4717 1683 5179 1872 426 391 14180

2012 6001 2972 6229 2894 608 592 19207

2013 8551 4812 7004 3000 766 819 24952

Table 2.

Size and composition of Chinas shadow banking (unit: RMB 1 billion)


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Exhibit 2.

Component Shares of Net TSF

Source: Peoples Bank of China / Haver Analytics

Exhibit 3.

China: Social Financing Stock (in % GDP)

Note: in percent of 4Q rolling sum of quarterly GDPSource: International Monetary FundData Source: CEIC; and IMF staff calculations

shadow banking consists of loans that are originated bythe banks and would have been made directly by themand retained on their books were it not for regulatoryconstraints or outright prohibitions. This segment hasgrown very quickly because the relative advantages ofbeing organized as a bank are declining for many of theiractivities.

Non-bank channels have a number of key advantagesover banks and these are encouraging the growth ofshadow banking:

Banks run into absolute caps on their lending volumes.PBOC loan quotas are constraining the ability of

most banks to lend as much as they would otherwisechoose to do. This factor varies over time. In 2009, thegovernments stimulus program largely ran throughthe banks and resulted in loan quotas that were verygenerous, along with clear encouragement to lend up totheir quota levels. However, in recent years the quotashave been a signicant constraint.

The loan to deposit cap of 75% is constraining. Evenif the loan quotas would allow, most banks are ndingit difcult to raise inexpensive deposits sufcient tofund their loan growth while meeting the 75% cap. Thelimitation on deposit rates has led many depositors


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to search for higher yields through the purchase ofwealth management products or real estate or stocksor other instruments. Corporate depositors in particularhave often found it easy and attractive to channel theirmoney to banks through the inter-bank market or wealthmanagement products, rather than traditional deposits.Regulators recently moved to include more of these

non-traditional deposits and quasi-deposits in the 75%calculation in order to loosen the practical effect of thisconstraint.

Regulators discourage lending to certain industries.At any given time, bank supervisors push banks awayfrom loans to certain types of borrowers. Currentlythat includes local government nancing vehicles, coalminers, ship builders, real estate developers, and someother groups. Banks, however, may still wish to makesuch loans, in which case they may need, or desire, tokeep them off their own books and therefore to run themthrough other channels.

For example, the real estate sector was struck at thebeginning of 2010 by a new round of macro-controlsincluding home-buying restrictions, designed to counterthe rapid increase in Chinese housing prices from thesecond half of 2009 to the rst half of 2010. After banklending to the real estate industry peaked at 2.05 trillionin 2009 and 2.09 trillion in 2010, it shrank to only 1.32trillion and 1.37 trillion in 2011 and 2012. The tighteningof bank lending placed enormous nancial pressure ondevelopers, thus spurring the industrys strong demandfor external nancing which has been an importantdriving force behind the rapid growth of shadow bankingsince 2010.

Similarly, in 2009, at the beginning of the credit boom,infrastructure investment led by local governmentinvestment platforms played a particularly signicantrole in the surge of investment in China. However, somelocal nancing platforms struggled with issues such asoverstated equity capital, unduly high leverage, and poornancial management, as well as extremely low rates ofreturn. Therefore, after the State Council promulgatedArticle 19 in 2010 (State Councils notice on issuesrelated to strengthening local government nancingunit management), the CBRC and the PBOC began torestrict commercial bank loans to local government

nancing units. Further, in October 2014, the StateCouncil issued Document 43, which limited the ability oflocal and regional governments to support loans madeto companies, apparently including local governmentnancing vehicles. This caused many lenders to pull backfrom such loans.

However, the investment projects carried out under thelocal nancing system are mostly long-term construction

projects, which are likely to go unnished unlessadditional nancing is obtained. To avoid this, localgovernment nancing units turned to shadow banks toobtain additional nancing, mainly through infrastructuretrusts (construction trusts) or brokering special assetmanagement schemes.

Most non-bank channels have lower capital requirements.When a loan is retained on the books of a bank, it musthold equity equal to about a tenth of the loan value.Equity is expensive and banks prefer to minimize theneed to raise it. Keeping a loan off of the balance sheetof a bank, or carrying it in a form that does not requireas much capital as a loan, is therefore attractive. Forexample, it was possible to have the economics of aloan passed back to a bank as Trust Beneciary Rightpayments and to carry this on the balance sheet as aninvestment in the securities of a nancial institution,which required less capital than holding a loan. Thisloophole has largely been closed, but others like it

continue to account for some of the attraction of shadowbanking.

Greater pricing exibility. This has become less importantas the regulation of interest rates on loans has beenliberalized, but was one factor in encouraging the use ofnon-bank channels.

Avoidance of PBOC reserve requirements. Banks areburdened by the need to hold about a fth of theirdeposits at the PBOC, earning low interest rates. Wealthmanagement products that are close substitutes foractual deposits do not have this burden.

Banks have chosen to create their own shadow bankingproducts, such as wealth management products, andto cooperate with shadow banks in order to escape theconstraints and disadvantages described above. Forexample, banks started to team up with trust companiesto make loans to bank customers. A trust company mightborrow from the bank and use the funds to make a loanthat the bank would otherwise have made on its own. Itcould then package this loan into a trust vehicle and sellback to the bank the rights to receive all the paymentsfrom the trust, which would consist of the principal andinterest payments from the borrower. Thus, the bankwould have satised the customers need for funding

while obtaining for itself the economic benets, and risksof the loan, with the exception of a modest fee retainedby the trust company. Regulators have largely eliminatedthis simple version of such transactions, but banks andshadow banks have continued to evolve more complexways of accomplishing the same ends.

The other one-third of shadow banking appears to arisefrom a reluctance or inability of banks to effectively lend


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money to certain segments, plus a natural tendencyfor some business to be won by non-bank competitorseven when competing on a level playing eld. As notedearlier, the major Chinese banks are not structured wellto provide loans to SMEs and they do not have muchcredit experience in this area to allow them to adequatelyjudge the level of risk. They have been pushed by the

authorities to raise their lending in this area, but muchof that increase appears to have been achieved throughgaming the system, such as by lending to smallerafliates of large SOEs and categorizing that as anSME loan.

Chinese banks also face some subtle, and likelyunintended, regulatory pressures not to lend to SMEs.For example, it has been reported that bank regulatorsare pushing banks hard to keep their non-performingloans below one percent of their total loans. This is anunrealistic goal for any bank with a large proportion ofloans to SMEs, since, in the down part of a credit cycle,

average losses should be substantially higher than that.This is not of itself a sign of bad lending, since the loanpricing for SMEs should be substantially higher preciselyto compensate for higher average credit losses.

In addition, as noted earlier, the authorities discouragebank lending to various sectors such as coal mining orreal estate development. Some of their loan demand ismet by bank use of shadow banking channels, but otherportions end up moving entirely to non-bank institutionswith no connection to banks.

Finally, well-run non-bank nancial institutions shouldhave competitive advantages of their own, including

close client relationships, and would be expected to winsome share of credit business even without specic

structural weaknesses or limitations for the banks.Some of the non-bank nancial institutions are moreentrepreneurial than the relatively bureaucratic banksand do a better job of meeting customer needs at areasonable cost.

So far, this section has focused only on lending. Theother side of shadow banking is the use of non-bank ornon-traditional products as funding sources. Investorsin shadow banking products are primarily domestichouseholds but also include corporate and nancialinstitutions. Traditionally, household investment optionswere largely limited to bank deposits, equities, realestate, and foreign exchange. Shadow banking products,principally WMPs were devised with superior appealfor many investors compared to these traditionalinvestments, as shown by strong fund ows into all kindsof shadow banking products.

Previously, the only safe asset was a bank deposit,but deposit rates are constrained by a rate cap, which

for some years now has been held below the rate ofination, although this dynamic has changed recently,on at least a temporary basis, as ination has fallensharply. Compared to this, shadow banking productsassociated with the banks and trusts had much moreattractive yields while being seen as essentially equallysafe by many savers. However, the majority of potentialdepositors either prefer the unambiguous safety of bankdeposits or have difculty accessing WMPs.

The other higher return investment options, primarilyequities, real estate, and foreign currencies, carriedsubstantial risk. In contrast, shadow banking products

were generally perceived as guaranteed by the banks andtrusts involved in their origination.

Exhibit 4.

WMP Outstanding Amount and Share of Deposits

Source: International Monetary FundData Sources: CRBC, CEIC, local media, and IMF staff calculations


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Thus, a search for safe, yet higher yielding, investmentsspurred households and businesses to snatch up wealthmanagement products as they came to be offered.

As shown in Exhibit 412, WMPs have grown to be asignicant portion of total deposits and quasi-deposits,although still only about a tenth of the total. Corporatedeposit substitutes, usually invested via the inter-bankmarket, would need to be added as well. However, thegreat bulk of the funding is still in the form of traditionalbank deposits.

How does Chinese shadow bankingrelate to the formal banking sector?

There are multiple ways in which the formal bankingsector has a stake in the health of the shadow bankingsector. These are summarized well in a Sanford Bernsteinreport by Hou, Gao, and Zhou (2014). Exhibit 513below is

taken from that report:The exhibit leaves out two other forms of exposure. First,banks do make on-balance sheet loans directly to non-bank nancial institutions. These would be transparentlyshown on the banks balance sheets, which is why theywere not listed in the exhibit. Second, banks or their

12. See IMF (2014b), p. 29.

13. Hou (2014), Exhibit 53 (p. 34).

afliates sometimes have ownership stakes in trustcompanies or other non-bank nancial institutions. Onthe whole, such stakes are not large for the bankingsystem as a whole.

Two of the relationships shown in Exhibit 5 are worthfurther explanation. Trust Beneciary Rights havealready been described above. A trust company maymake a loan to a bank client, with the agreement thatthe bank will essentially buy the loan back by purchasinga TBR. Even more straightforwardly, banks may enterinto repurchase agreements using loans or WMPs ascollateral, so that the trust company knows that theultimate economic risk will fall on the bank. The trustcompanys own risk is therefore simply the counterpartyrisk of the bank.

Hou, Gao, and Zhou (2014) provide an estimate of theshadow banking exposures of eight banks that comprisethe bulk of the banking system in China. Tables 3 14and 415

(next two pages) below is taken from their report.

The report further quanties the potential loss of annualearnings from 2014-18 for these banks, depending on thecumulative rate of non-performing loans and the portionof losses borne by the banks. The authors of that reportbelieve the best estimate is of a 15% non-performingloan rate and a 40% share of the resulting losses for

14. Ibid, Exhibit 57 (p. 37)

15. Ibid, Exhibit 60 (p. 28)

Exhibit 5.

Linkages between the formal and shadow banking sectors

Source: Sanford Bernstein reseaerch


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On-balance sheet quasi-credit exposures

Off-balance sheet wealthmanagement products

Off-balance sheetcontingent liabilities

Estimated size RMB 4.3 trillion RMB 3.1 trillion RMG 8.4 trillion

Exposure prole

Investment with trust relatedunderlying: e.g. Directinvestment in Trust beneciaryrights (TBRs), Third party trustexposures, Resale agreementsbacked by TBRs

Non-principal guaranteedwealth management products(WMPs) with non-standardcredit assets (e.g. trust loans) asinvestment targets

Mainly bank acceptances billswhich are used by corporatefor payment and short-termnancing purposes

Bank linkageOn bank balance sheet butunder inter-bank / investments/ receivables

WMPs sold by banks as agentsand not consolidated ontobalance sheet

Contingent liabilities off bankbalance sheet until the bills arediscounted

Underlying riskprole

HIGHTypically trust loans extendedto high risk borrowers such asreal estate developers, localgovernment nancing vehicle(LGFVs) and manufacturingrms

HIGHAlso typically high riskcorporates or LGFVs, whichcannot obtain loans throughtraditional bank lending directly

LOWWith short-duration (typically3-6 months), acceptance billsare mostly used in workingcapital management bycorporates and are low riskcompared to standard corporateloans

Estimatedcumulative NPLformation(2014-18)

8-10% (similar to on-balancesheet high risk sectors total NPLformation through the cycle)

10-15% (about 1.5-2x that of on-balance sheet high risk sectorstotal NPL formation during thesame period)

0-0.5% (Historically verylow NPL formation rate indiscounted bills, at 0-10bps peryear)

Loss contingency

As these are on-balance sheetexposures, banks will haveto take 100% of lossesifborrowers default

Contractually no obligation forbanks to take part in the lossesHowever, implicit guaranteesfor investors persist in themarket, which put banks at riskof being forced to share someof the losses during the work-out process

100% losses will be absorbedby the bank as the productconsolidated onto balance sheetonce discounted

Bank treatmentUnder-provisioning for theseexposure by classifying them asinterbank / investment assets

No provisioning for theseexposures as they are offbalance sheet

Counted towards risk assets andthus capital calculation but arenot provisioned until overdue

Table 3.

Shadow banking exposures of eight major banks

Source: Bank reports, Bank IR teams, Sanford Bernstein analysis and research


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the banks. The other 60% of the losses would be sharedin some manner between investors in WMPs, the trust

companies and securities companies that were alsoinvolved, local and national governments, etc.

Bearing in mind that these estimates of the size ofexposure and ultimate losses are merely estimates byone well-informed set of equity analysts, the relativelysmall size of the calculated potential direct impacts onthe major banks strongly suggests that if a crisis were tospread in a major way from shadow banking to the formalbanking sector it would have to be through some indirectmanner, such as a loss of condence in the nancialsystem that led to runs. Such possibilities are discussedfurther below.

How does the size and structure ofshadow banking in China compareto other countries?

Bearing in mind the considerable uncertainty anddisagreement about denitions of shadow banking, thissection compares Chinas shadow nance sector withthose in other countries, on the dimensions of: scale;types of actors; types of instruments; and degree ofsystemic risk created.

ScaleUnder the broadest denition of shadow banking adoptedby the FSB and the IMF, Chinas shadow banking sectoris much smaller, relative to the size of its economy, thanthose of the US, the UK and the Eurozone. The FSBestimates that, at the end of 2013, global assets held byother nancial intermediaries (OFIs, that is nancialinstitutions other than central banks, banks, pension

funds and insurance companies) were US$75 trillion,accounting for 24% of all nancial assets and 120% of

GDP. For China, the comparable gures were roughly9% of nancial assets and 31% of GDP in 2013; total OFIassets were thus less than one-eighth of total bankingsystem assets. (Note that for consistency of comparisonwe use the FSBs estimate of Chinas shadow sectorrather than our own; the FSBs estimate of 31% of GDP in2013 is somewhat lower than our calculation of 43% ofGDP in 2013, but not by enough to invalidate our broadconclusions about the size of Chinas shadow sectorcompared to those of other countries.)

In the United States, by contrast, the FSB estimatesthat OFI assets were around 150% of GDP (US$25 trn),

about a quarter more than the assets of the U.S. bankingsystem (120% of GDP). Three European countries whosebanking systems are all substantially larger, relativeto GDP, than Chinas, also have gigantic OFI systems:Netherlands (760% of GDP), the UK (348%) andSwitzerland (261%).16 (See Table 5 next page)

Another way of expressing the same data is to notethat, of global assets controlled by OFIs in 2013, 33%were in the US, 34% in the Eurozone and 12% in the UK.Whichever way one looks at it, it appears that Chinasshadow nancial system is relatively small in both theglobal and the domestic context.

The broad FSB estimates are not without their problems,however. Some critics object that by focusing onnon-bank entities, the FSB ignores shadow-bankingactivities carried out by banks themselves. As a result,the size of Chinas shadow banking sector may well

16. Financial Stability Board, Global Shadow Banking Monitoring Report2014, November 4, 2014 (http://www.financialstabilityboard.org/2014/11/glob-al-shadow-banking-monitoring-report-2014/).

Cumulative NPLformation

5% 10% 15% 20% 25% 30%

Cumulative loss

formation (NPLformation * LGD @ 80%) 4% 8% 12% 16% 20% 24%

Banks shareof Loss in off-balance sheetWMPs

10% -0.1% -0.3% -0.4% -0.6% -0.7% -0.8%

20% -0.3% -0.6% -0.8% -1.1% -1.4% -1.7%

30% -0.4% -0.8% -1.3% -1.7% -2.1% -2.5%

40% -0.6% -1.1% -1.7% -2.2% -2.8% -3.3%

50% -0.7% -1.4% -2.1% -2.8% -3.5% -4.2%

60% -0.8% -1.7% -2.5% -3.3% -4.2% -5.0%

Table 4.

Bank risk due to shadow banking

Source: Bank reports, Sanford Bernstein analysis and estimates


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be underestimated.17This critique is just, but on closeinspection it is unlikely to really affect the overallconclusion that Chinas shadow nance sector issubstantially smaller than those of nancially advancedcountries such as the U.S. and the UK.

First, the same objection applies to all countries, not justChina, so to make a fair comparison one would have toestimate the shadow-banking activities of banks in allcountries. Such an exercise would raise the estimates forthe volume of shadow activity everywhere, not only inChina.

Second, the biggest shadow banking activity of banksis the issuance of WMPs, but these are liabilitiesofnancial institutions, whereas the FSBs shadow bankingestimates involve assets. Lumping together liabilities andassets results in double counting. The FSBs estimatesalmost certainly involve a fair amount of double counting

anyway, since a chain of transactions among a seriesof nancial institutions means that an equivalent assetis held on multiple balance sheets. But, in the absenceof clarity on how much double counting exists in theFSB numbers, it does not seem appropriate to adjustChinas gure upward by including instruments thatare unambiguously liabilities, not assets, of nancialintermediaries.

Some may argue that although Chinas shadow sectoris clearly smaller than that of nancially advancedcountries, it is larger than that of other developingcountries. This is not really borne out by the FSBsgures, which show that South Korea, South Africa,Brazil and Chile all have non-bank nancial sectorslarger (relative to GDP) than Chinas. But the gap ismuch smaller than with the advanced economies ofNorth America and Europe, and if one accepts theclaim that Chinas gross shadow activities are uniquelyunderestimated because of an unusually large proportion

17. Borst (2014), pp. 12-13,71.

of shadow activities undertaken by the banks themselvesit is plausible that Chinas shadow sector could bethe largest (relative to GDP) in the developing world.Certainly it is unambiguous that Chinas formal bankingsector, at 272% of GDP at end-2014 is the developingworlds largest.18

By the broad denition, therefore, Chinas shadownance sector is much smaller relative to both GDP andthe formal banking system than in nancially advancedcountries. It may possibly be on the large side for adeveloping country. Further, and perhaps most importantit was by far the fastest growing shadow system in theworld, with assets increasing by 34 percent in 2013compared to a worldwide average of 7%. 19

Moreover, on the narrowdenition of shadow bankingintroduced by the FSB in its latest monitoring report,the relative size of Chinas shadow sector becomes

larger. This narrower measure tries to strip out equitynancing and self-securitization activity. These functionscomprise a large share of OFI activity in the US, UK, theNetherlands and some other countries, but are relativelyinconsequential in China. By this metric, Chinas shadowbanking system, while only one sixth the size of theU.S. system, is in absolute terms the third largest in theworld20. The general point still holds that Chinas shadowbanking system is smaller relative to GDP and totalnancial assets than in most advanced countries. Butits large absolute size, and rapid growth, are legitimatecauses of concern.

Types of InstitutionsThe FSB divides the universe of non-bank nancialinstitutions into the following categories21:

18. China Banking Regulatory Commission and the National Bureau of Statistics of China, accessed via Haver Analytics, up to date as of March 9, 2015.

19. FSB 2014, p. 12.

20. FSB 2014, p.23, Exhibit 5-2

21. FSB 2014, pp. 13-14

Shadow Banking Assets as % of 2013 GDP

Netherlands 760%

United Kingdom 648%Switzerland 261%

United States 150%

China 31%

Table 5.

Shadow banking size comparison


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Investment funds, excluding pension funds andinsurance companies (accounting for 38% of globalNBFI assets in 2013, of which a bit under half wereequity funds and a third were bond funds)

Securities broker-dealers (15% of NBFI assets)

Structured nance vehicles (8%, concentrated

heavily in the U.S. and the UK) Finance companies (6%)

Money market funds (6%)

Nation-specic institutions (such as U.S. nancialholding companies and Dutch special nanceinstitutions; 12%)

Others including hedge funds, real-estate investmenttrusts (REITs), trust companies, and others (15%

The IMF provides useful schematic diagrams of how theshadow nance sector relates to the traditional banking

sector (IMF 2014, Figure 2.3, p. 69), and how the variousactors in the U.S. shadow banking universe interact witheach other. (IMF 2014, Figure 2.1.1, p. 70).

The institutional universe in China is, by contrast, farless diverse. Hedge funds, REITs, specialized nancecompanies and structured nance vehicles are negligiblein size, and domestic money market funds have untilrecently been very small (although one can argue thatmany WMPs issued by banks and trust companies are inessence money-market funds, see Borst 2013). Securitiesrms do exist, but their assets are modest (about one-twentieth of bank assets), and for the most part they donot extend credit. (These rms do engage in signicant

margin lending to equity investors, although regulatorshave taken steps to limit this.) See Exhibits 722and 823.

The most notable vehicles for the provision of shadowcredit in Chinaaside from the banks themselvesarethe trust companies. These rms collect funds fromwealthy individuals and companies and invest them ina range of credit instruments, generally bearing higherinterest rates and carrying higher risk than normalbank loans. They are separate from but often cooperateclosely with banks and in a few cases are partially or fullyowned by them, although banks are not major investorsin trust companies on the whole. At various pointstrust companies have been sanctioned by regulatorsfor providing conduits for banks to park loans off-balance sheet.24At the end of 2012, total trust companyassets were about 12% of GDP, roughly the same as forsecurities companies.

Types of Activities and Systemic Risk

It may be more useful to employ an activity-basedestimate of shadow nancing, rather than the entity-based method used by the FSB in its global survey,particularly given the large role of banks in Chineseshadow banking. This also has the merit of being theapproach favored by the Peoples Bank of China, whichmonitors shadow banking activity through its Total SocialFinance measurements.

On a stock basis, the TSF numbers ratify the FSBsconclusion about the relatively small size of the shadow

22. IMF, Global Financial Stability Report 2014, Figure 2.3 (p 69).

23. Ibid., Figure 2.1.1 (p.70).

24. Borst (2013).

Exhibit 6.

China Credit Growth, 2010-2014 (% yoy change)

Source: Sanford Bernstein reseaerch


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Exhibit 7.

Tradtional vs. Shadow Banking Intermediation


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sector in China, relative to conventional bank loans. Atthe end of 2013, domestic and foreign currency bankloans accounted for 71% of the TSF stock. Loans by trustcompanies accounted for another 4%, and entrustedloans 7%. Bankers acceptances accounted for 6%, andcorporate bond issues another 3%.

How much of this activity reasonably qualies asshadow nance according to international denitionsis debatable. Trust loans clearly do, since they are a formof credit extended by a non-bank institution. One couldargue that virtually nothing else does, either becauseit is credit extended by banks (for example, bankers

acceptances), intercompany lending (entrusted loans)or direct fundraising by corporates (bond issues), whichare not counted as shadow nance anywhere else in theworld. On this basis, the widely respected China bankingsystem analyst Stephen Green suggests that Chinastrue shadow banking was only 8-14% of GDP in 2013.25This extremely low estimate is perhaps defensible, but

25. Green (2014).

given the opacity of nancial activity in China, and itsextremely rapid growth, using a broader denition ofshadow activity (as we have done above by includingtrust loans, bankers acceptances, and renancing inthe inter-bank market) is probably prudent. The centralobservation is that even using this broader denition,Chinas shadow sector is not unusually large.

Leaving aside the basically denitional question of justhow big Chinas shadow sector is, what is the natureofthese shadow activities? Most Chinese shadow bankingconsists of straightforward lending, sometimes thinlydisguised. Banks would likely provide the great bulk of

this lending directly and hold it on their balance sheetswere there not a series of regulatory constraints on theamount and pricing of their loans, as described earlier.

These limits, and other constraints and incentives,hold down total bank lending and divert credit to otherchannels. Further, various distortions in the economyhave made it protable for SOEs to borrow from banksand on-lend to other borrowers, which accounts for

Exhibit 8.

U.S. Shadow Banking System


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part of the entrusted loans category. This reduces thevolume of potential bank lending for all other forms ofcredit, given the limits, and directly raises the level ofshadow banking, if one includes entrusted loans in thatcategory, as we do in this paper.

Will there be a major shadowbanking crisis in China?

To summarize our conclusions so far:

Chinas shadow banking sector, however dened, issubstantially smaller (relative to GDP) than thoseof nancially advanced countries in North Americaand Europe, and towards the middle of the range formajor developing countries.

Chinas shadow banking sector has been, however,by a wide margin the fastest-growing in the world,and sits alongside a formal banking sector which, at

272% of GDP, is very large by developing-countrystandards.

Trust companies are the dominant type of non-banknancial institution engaging in shadow lending.Most other shadow banking activities are undertakenby the banks themselves, or by SOEs which use banksor trust companies as conduits for their loans.

There is less use than in the West of practices orinstruments such as securitization, derivatives, CDOsor CDS, although securitization is growing. However,WMPs and instruments such as Trust BeneciaryRights and repurchase agreements using loans ascollateral bring some of the same risks and can beopaque. Fortunately, they are generally unleveragedand therefore less dangerous in a nancial crisis thanwas true of many products used in the West. Theywould also likely be brought back onto the booksas loans, which would not require that they bemarked to market and therefore they may producea lower hit to capital in the midst of a crisis.

Most shadow credit is straightforward lending; themajor purpose of shadow nance is simply to satisfynormal demand for credit that cannot be met bybanks under their existing mandated loan-to-deposit

ratios, reserves, capital ratios, and other regulatoryand supervisory constraints.

Funding risk is lessened by the fact that, inaggregate, nancial sector exposures are more orless fully covered by bank deposits. This does notpreclude funding problems at the shadow banks,but means that aggregate resources are availablethat could be readily deployed under the right policyregime.

These conclusions suggest that the near-term risk to thenancial sector and the wider economy from a shadowbanking crisis in China is low. There is certainly a real riskof a crisis withinthe shadow banking sector. However, ifsuch a crisis did occur, say via the serial bankruptcy ofseveral trust lenders, it is likely that the impact of thecrisis could be contained and would not lead to serious

contagion in the rest of the nancial system. Banks wouldlikely share in some of the losses, but are large enough tohandle the potential damage. This said, there remains thepotential for a number of the shadow banks themselvesto face insolvency in a crisis.

The major risk in the shadow sector is that some trustcompany lendingfor instance to real estate developersor companies in nancially stressed industries such ascoal miningis intrinsically risky, and moreover suffersfrom a maturity mismatch, with loans of two years ormore in duration often funded by WMPs with a maturityof 6 months or less. One can easily imagine a severe

downturn in the property market and the heavy industriasectors that depend on construction demand leadingto a wave of defaults on trust loans, which would thencause trusts to default on their WMPs. This would beunpleasant, but it is unlikely to produce the cascadeeffect seen in the U.S. in 2008.

First, trust companies do not provide liquidity to thenancial system, except by facilitating WMPs issuancethat could be replaced by deposit issuance. So whilea buildup of bad assets on their balance sheets wouldbe a headache for them (and for any banks that lent tothem), it would have little direct impact on the nancialsystems ability to fund itself, beyond the trust companiesthemselves. Second, the indirect effect of stress inthe trust sector would most likely to be to improvetheliquidity position of the banks. This is because a crisis ofcondence in trust-issued WMPs would lead individualinvestors to y to the safety of state-guaranteed bankdeposits.

In its present form, therefore, Chinas shadow bankingsector presents relatively low risk of triggering a panicor nancial crisis similar to those experienced by theU.S. in 2008, or by other Asian economies and Russia in1998. The fundamental reason for this is that liquidityis abundant, due to the high levels of deposits from

households and businesses, and reliance on fragilewholesale funding sources is minimal. Bad events suchas a property market crash, a dramatic heavy-industryslowdown, or defaults in the trust companies wouldcertainly increase banks non-performing assets, but theywould not imperil banks funding.

The bigger nancial system risk in China is not crisis butsclerosis: if an ever greater share of lending (whether bybanks or shadow entities) goes to unproductive projects,


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then economic growth will continue to decelerate. Thisis in essence what occurred in Japan in the 1990s. Aserious shrinkage of the shadow banking sector wouldexacerbate this risk, by reducing the available volumeof credit, increasing its price, and pushing more of thelending that does occur back into a banking sector thatis still somewhat limited in its ability to effectively lend

outside of the SOE realm.

How do Chinese authorities intendto reform shadow banking?

Since the emergence of wealth management productsand trust loans on a large scale in 2010, the principalnancial regulators, the PBOC and the CBRC, have takena cautiously welcoming view of the shadow sector. Thebasic idea was that shadow activities help satisfy thedemand of investors and depositors for a wider range ofnancial instruments, beyond the low-yielding regulated

deposits and the illiquid real-estate investments that untilrecently were the principal investment options for mostChinese. Trust loans were also a useful mechanism fornancing higher-risk borrowers, at appropriately higherinterest rates.

At the same time, however, regulators had two broadconcerns: rst, that an unregulated shadow nancesector could create excessive credit growth; and second,that the lack of transparency in the sources and uses offunds could create hidden risks, much as occurred in theU.S. before 2008. Regulatory efforts since 2013 thereforefocused on:

Slowing down the pace of non-bank credit growth.

Disciplining the use of the inter-bank market forfunding.

Requiring the composition of shadow assets andliabilities to be made more transparent.

As the chart below indicates, virtually all of the credit

expansion in 2012 and early 2013 came from sourcesother than bank lending. Year on year growth in thestock of traditional bank loans rose only from 14% to 16%during 2012, and then drifted gradually back down toaround 14%. Growth in the totalcredit stock, meanwhile,accelerated from 16% in early 2012 to nearly 23% in therst quarter of 2013. The monetary tightening imposedby the new government beginning in May 2013 camealmost exclusively through a slowing in the pace of non-bank lending, which brought growth in total credit downto below 15% despite virtually no change in the pace ofbank lending.

Discipline on the inter-bank market began in June 2013,when the PBOC engineered a liquidity squeeze thatbriey drove overnight interest rates to nearly 30%.The mini-panic that ensued in nancial markets forcedthe PBOC to backtrack temporarily, but over the restof the year inter-bank and other short-term fundingrates gradually rose, ending the year 2-3 percentagepoints higher than they had begun it. One of the mainpurposes of this exercise was to curb the enthusiasm ofsmaller banks that had been borrowing heavily on theinterbank market to fund higher risk lending activity,often routed through shadow banking. The PBOC didnot adequately communicate its intentions, and markets

were temporarily unsettled as a result, but the regulatory

Exhibit 9.

Credit growth has accelerated from the bottom


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intent was straightforward and sensible: to prevent therise of shadow nance from creating a systemic fundingrisk.

Efforts to make shadow activities more transparentare embodied in a series of regulatory documents: the

State Councils Notice on Some Issues of Strengtheningthe Regulation of Shadow Banks (Document No. 107,January 2013); the multi-agency Notice on RegulatingFinancial Institutions Interbank Business (State Councildocument no. 127, May 2014), and the CBRCs Noticeon Regulating Commercial Banking Interbank Business(document no. 140, May 2014). Document 107 essentiallybanned the practice of fund pools, under which trustcompanies and other WMP issuers could move moneyindiscriminately from one investment to another. Thishad made it impossible for buyers of a given WMP toknow what exactly they were investing in. The other two

notices proposed new rules for nancial institutionsmanagement of interbank liquidity. Among otherthings, institutions are required to place limits on theirexposures to individual counterparties and meet capitalrequirements for off-balance sheet transactions (such asrepurchase agreements) that previously did not need tobe backed by capital.

Conclusions

Chinas shadow banking sector is not especially largeby international standards, is relatively simple, and

is overseen by regulators who have so far shownthemselves alive to the most important risks (namelyfunding risk and lack of transparency) and have takenprudent steps to minimize these risks. The authoritiestake seriously their mandate to maintain nancialstability, and have acted pre-emptively (for instance inthe interbank squeeze of June 2013) to nip practices inthe bud that might threaten that stability.

The problem for Chinas nancial authorities is that thevery large traditional banking sector is not fully servingthe increasingly complex nancial needs of an economytransitioning from a focus on industry and infrastructureto one based mainly on consumer services and alsomoving from state ownership and control to a greaterlevel of private enterprise.

The balancing act between encouraging shadow banks tosupply needed credit to sectors that are not well servedby traditional banks and at the same time protectingnancial stability and investors is a very difcult one. Wewill shortly be issuing a companion paper that providesrecommendations for policy actions by the Chineseauthorities.


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Pozsar (2012) provide a more rened description of shadow banks, dening them as nancial intermediaries thatconduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sectorcredit guarantees.26This denition hinges on the notion that only those forms of credit intermediation that receive

directand explicitpublic sector guarantees against losses and access to central bank liquidity may be considered part ofthe formal banking sector. Therefore, off-balance sheet activities that occur at bank holding companies, such as specialpurpose vehicles (SPVs) with privately provided backstops, are considered shadow banking since they only receiveindirect public guarantees. Similarly, intermediation activities that occur at money market mutual funds (MMMFs) areconsidered part of the shadow banking system since they, at best, receive only indirect or implicit public sector creditenhancement.

Claessens (2014) describe it as all nancial activities, except traditional banking, which require a private or publicbackstop to operate.27Private backstops generally come in the form of the franchise value of another nancialinstitution, while public backstops tend to be public guarantees on debt securities, public deposit insurance, or explicitaccess to central bank liquidity.

26. Pozsar (2012).

27. Claessens (2014).

Appendix A


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Estimates of the Size of the Chinese Shadow Banking System

SourceEstimatePeriod

RMB(trillion)

USD(trillion)

% of GDP Description of Components

IMF(Oct-14)

Mar-2014 19.9 2 3.32 35% of 2014 GDP

Total social nancing less bank loans, equity-likeitems, and bond issuance. Entrusted loans andtrust loans account for a large share of shadowbank social nancing.

UBS(Mar-14)

YE-201328.4 39.8

4.7 6.6 50-70% of 2013 GDP

Range based on three different denitions ofshadow banking. All denitions include trust andentrusted loans, commercial bills, other trustassets, and Other items. Denitions vary basedon inclusion of informal lending and corporatebonds not held by banks.

Financial StabilityBoard

(Oct-14)

YE-2013 18.2 3.0 31.2% of 2013 GDPIntermediation conducted by non-bank nancialinstitutions excluding insurance companies,pension funds, and public nancial institutions.

Standard Chartered(Mar-14)

YE-2013 4.6 12.5 0.7 2.1 8-22% of 2013 GDP

Dened as credit intermediation by non-bankinstitutions and excluding inter-companylending and bond issuance, shadow bankingwould consist of trust loans, estimated at 8% ofYE-2013 GDP; if under-reporting of trust activityis assumed, that gure may be closer to 12-14%;if peer-to-peer lending, which is estimated atapproximately 8% of GDP, is also included thenthe previous gure ranges from 20-22%

Bangkok Bank(Mar-14)YE-2012 36.4 6.0 70% of 2012 GDP Shadow banking is high-yield lending outsidenormal bank lending channels.

JP Morgan(Jan-14)

YE-2013 46 7.5 80.9% of 2013 GDP N/A

Chinese Academyof Social Sciences

(CASS)(Oct-13)

YE-2012 16.9 3.0 36% of 2012 GDPUsed narrow denition with only banks wealthmanagement products and trust companies trustproducts

JP Morgan

(May-13)

YE-2012 36.0 5.8 69% of 2012 GDP

Broad denition of all non-bank creditintermediation applied.This denition includes investments madeby trust companies, entrusted loans, bankers

acceptances, wealth management products,intermediation by other nancial institutions(OFIs), and underground lending.

China InternationalCapital Corporation

(Apr-13)

Apr-2013 27.0 4.4 52% of 2012 GDP N/A

Appendix B


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Fitch Ratings(Apr-13)

YE-2012 31.2 5.0 60% of 2012 GDPMain components include peer-to-peer lending,trust loans and bankers acceptances

Standard & Poors(Apr-13)

YE-2012 22.9 3.7 44.4% of 2012 GDPWealth management products, trust companyproducts, entrusted loans, and private loans

Emerging AdvisorsGroup (Feb-13)

Sep-2013 22.8 3 3.7 3 40% of 2013 GDP

Using standard international denition ofshadow banks as formal non-bank entities thatcarry out bank-like credit activities, includingcredit from trusts and direct credit from nancialcompanies other than banks.

Deutsche Bank(Jan-13)

Jan-2013 20.0 3.2 38% of 2012 GDP N/A

UBS(Oct-12)

Q3-2012 24.4 3.8 46.5% of 2012 GDP

Based on broad denition, including outstandingcommercial bills, trust and entrusted loansincluded in TSF, trust assets not included in TSF,informal lending, and corporate bonds not heldby banks

GaveKalDrogonomics

(Apr -12)

YE-2012 19 3.0 36.6% of 2012 GDPIncludes micronance, private lending, trustloans, designated loans, letters of credit, andbankers acceptances (net)

UBS(Oct-11)

H1 - 2011 10.0 1.5 23.6% of 2010 GDPShadow banking refers to non-bank loans suchas entrusted

shadow banking in china

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