Shadow banking can broadly be described as the system of credit intermediation involving entities and activities outside the regular banking system. In developed countries, the biggest shadow banking players are usually hedge funds, venture capital and private equity funds.
However, in China, shadow banking has mainly taken the form of a large amount of wealth management products, or WMPs as they are known, underground finance and off-balance-sheet lending.
Chinese banks work closely with trust companies or other entities by packaging trust loans into WMPs, offering investors a higher yield than conventional bank deposits can. These products are mainly sold by commercial banks either at their branches or online. Many of the funds that were obtained through these channels went into real estate development, infrastructure projects, the manufacturing sector and local government financing vehicles. Banks are playing the role of "middlemen" between the recipients and investors.
It is difficult to measure the precise amount and value of WMPs. Fitch Ratings says that WMPs account for roughly 16 percent of all commercial bank deposits, while KPMG reports that trust companies will soon overtake insurance to become the second-largest sector in the Chinese financial industry. According to a report by CN Benefit, a Chinese wealth-management consultancy, sales of WMPs soared 43 percent in the first half of 2012 to 12.14 trillion yuan ($1.9 trillion).
There are more than 20,000 WMPs in circulation, a dramatic increase from only a few hundred just five years ago. Given that the number is so big and hard to manage, China's shadow banking sector has become a potential source of systemic financial risk over the next few years. Particularly worrisome is the quality and transparency of WMPs. Many assets underlying the products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations.
Moreover, many WMPs are not even linked to any specific asset, rather, just to a pool of assets, whose cash inflows may often not match the timing of scheduled WMP repayments.
China's shadow banking is contributing to a growing liquidity risk in the financial markets. Most WMPs carry tenures of less than a year, with many being as short as weeks or even days. Thus in some cases short-term financing has been invested in long-term projects, and in such situations there is a possibility of a liquidity crisis being triggered if the markets were to be abruptly squeezed.
In fact, when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme. Under certain conditions, the music may stop when investors lose confidence and reduce their buying or withdraw from WMPs. The rollover of a large share of WMPs could weigh heavily on formal banks' reputations, because many investors firmly believe that banks won't close down and they can always get their money back.
