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The risks and rewards of Chinese shadow banking
• 6 mins read
A new study finds fiscal stimulus transformed China’s bank lending, increasing shadow banking and exposing strategic shifts under regulatory pressures
Something lurking in the shadow may sound vicious but believe it or not, “shadow banking” is a legitimate business. Also known as non-bank financial intermediation, shadow banking refers to entities like money-market mutual funds, hedge funds, and private credit that offer financial services similar to traditional banks but with less regulation and oversight.
According to a 2023 report from the Financial Stability Board, the total financial assets of the shadow banking sectors by the end of 2022 was US$217.9 trillion globally, almost half of the total global financial assets in the same period at US$461.2 trillion. In China, the shadow banking industry reached US$12 trillion in 2019, according to a report published by the China Banking and Insurance Regulatory Commission (CBIRC).
Chinese banks operate shadow banking as a wealth management product while other Chinese financial institutions offer it as a trust product, offering interest rates higher than traditional bank deposits. This has driven substantial demand from investors. However, such appeal has been approached cautiously as many prominent players faced devastating fates, such as Xinhua Trust, which collapsed in 2023, followed by Zhongzhi Group and Sichuan Trust in 2024.
Su Yang, Assistant Professor of Finance at the Chinese University of Hong Kong (CUHK) Business School, observes that wealth management products mature in three to six months, but the raised funds are used to finance long-term projects like real estate. Therefore, fund managers need to roll over or renew the products frequently. “To delay default, fund managers will use proceeds from new investments to repay maturing obligations, creating a Ponzi-like game, eventually bursting at a higher cost for investors,” he says.
“The maturity mismatch between the investment and the assets can lead to serious problems on the asset managers’ side, particularly during the recent real estate crisis to which many funds are heavily exposed,” Professor Su adds. “Fund managers will find it difficult to repay maturing debt when the property price falls a lot, and the secondary market of properties becomes illiquid.”
In a study titled Fiscal stimulus, deposit competition, and the rise of shadow banking: Evidence from China, Professor Su, along with Viral Acharya of New York University, Jun Qian of Fudan University, and Yang Zhishu of Tsinghua University, looked into the dynamics of wealth management products issued by Chinese banks and how the competition among banks has fueled such products.
The year of shadow banking rises
The researchers looked at quarterly wealth management activity statements submitted to the CBRIC by 25 major and medium-sized banks in China from 2007 to 2014, as well as wealth management product balances from 135 banks from the CBRIC and individual wealth management product information from the Wind Economic Database.
The analyses found that less than 500 wealth management products were launched annually before 2007, but the number grew to more than 1,170 in 2007 and 4,080 in 2008, then rose to over 55,910 in 2015. The demand for wealth management products increased significantly after 2010. The government stimulus and competition among banks propelled the increase of wealth management products.
“The maturity mismatch between the investment and the assets can lead to serious problems on the asset managers’ side, particularly during the recent real estate crisis to which many funds are heavily exposed.”
Professor Su Yang
Specifically, when the 2008 Global Financial Crisis caused a sharp decline in exports, the government introduced a four trillion Chinese yuan stimulus plan. The Big Four banks, the Industrial and Commercial Bank of China, the China Construction Bank, the Agricultural Bank of China, and the Bank of China, played a crucial role by providing the lion’s share of the funds for the investment projects associated with the stimulus, leading to a large increase in loans and credit.
The Bank of China has been positioned to handle cross-border transactions since its inception. The weakening exports in 2009 threatened its deposits more than other banks. Meanwhile, the bank was also much more aggressive in lending money than other banks to support the stimulus plan. As a result, it became much more aggressive in attracting deposits.
After 2010, the average deposit rate premium offered by the Bank of China was significantly higher by about 0.2 per cent compared to the other big three. Small and medium-sized banks operating in the same region as the Bank of China felt intense competition and experienced lower deposit ratios, forcing them to issue more wealth management products.
“The effect of such deposit competition lasted until at least 2019,” says Professor Su. “Banks that were more exposed to Bank of China’s competition not only issued more wealth management products but also more modes to raise funds from the bank-to-bank lending market.”
The rollover risks of short-lived products
The central bank dictates how much money banks have to keep in their vaults and the limit of money being lent out compared to the bank’s deposits, prohibiting banks from lending more than 75 per cent of their total deposits. Wealth management products circumvent these rules and serve as a substitute for deposits without price control from the central bank.
After analysing information on wealth management products from the Wind Economic Database from 2007 to 2014, the researcher found significant clustering of products maturing exactly on the last day of the quarter. This timing coincides with the CBRIC’s inspection of the deposit ratio, indicating a deliberate setting of maturity dates so the issuing banks can boost total deposit balances on the inspection days.
When wealth management products mature, banks transfer funds from the investors’ accounts to their savings or deposit accounts, temporarily boosting the bank’s deposit balance. However, if a large amount of wealth management products mature on a particular day, banks will have to raise capital within a short window by rolling over new products. With the increasing scale of products to renew, banks would have to offer higher interest rates on new products to attract enough investors quickly.
“Increased reliance on shadow banking has two main problems compared to formal banking,” says Professor Su. “First, unlike deposits, which are the most stable source of funds for banks, shadow banking products are typically short-term and need to be rolled over frequently. Frequent rollover leads to more liquidity pressure and can lead to liquidity distress in bad times.”
“Second, bank depositors are protected by insurance and will not run on banks. However, shadow banking products are not insured in any way,” he adds. “When the shadow banks fail to deliver expected returns or investors lose confidence in them, investors will run on the shadow banks, and bank runs can sometimes force bankruptcy of even financially healthy institutions.”
To prevent unnecessary bank runs, Professor Su suggests strictly implementing information disclosure for transparency between shadow banks and investors. Investors should also realise the underlying risks of investing in wealth management products. “However, this needs to be built on the premise that the shadow banks themselves do not guarantee the investment return in the first place,” he adds.
