PBOC Shows Strongest Hand on China’s Shadow Banks

PBOC Shows Strongest Hand on China’s Shadow Banks

Inaction by Regulators Hampered Central Bank’s Efforts, Analysts Say

SHEN HONG

Jan. 7, 2014 1:36 a.m. ET

SHANGHAI—China’s move to step up regulation of its shadow-banking system highlights the weakness of its financial regulators, which have failed to slow the country’s lending boom even as top government officials raised concerns.The inability of China’s securities and banking watchdogs to limit the growth of lending outside traditional banks contrasts with the country’s central bank, which has emerged as the main bulwark against shadow banking.

The central bank, known to be relatively reform-minded, sought to control lending by engineering three financial squeezes—in June, October and December—that sent banks scrambling for cash and drove up short-term interest rates in the interbank lending market.

The squeezes were direct efforts to limit the lending boom because the banks and shadow banks that have been the most aggressive lenders generally depend on short-term borrowing to fund their loans. The problem was that by engineering a cash crunch—a relatively blunt instrument but one of the few available to it—the People’s Bank of China raised fears about the stability of the Chinese financial system.

The results of the squeezes have been higher interest rates, which can potentially slow the economy, and selloffs in the stock market. In June, concerns about the cash squeeze rippled through global markets.

China’s Banking System

China’s leaders are well aware that there’s too much infrastructure spending and too little spending by consumers, and they’re trying to “rebalance” the economy by easing interest rates and adding deposit insurance. The WSJ’s Ken Brown explains China’s financial system—with some help from claymation.

China’s cabinet last month distributed rules to regulators that call for stronger oversight of informal lending by the central bank and other regulators. The plan isn’t a crackdown on shadow banking, which suggests the leadership wants to preserve a key source of credit for the economy. But it addresses the risks that have been compared to the U.S. subprime credit boom that preceded the housing bust and financial crisis.

The document, which was reviewed by The Wall Street Journal, appears to address the split between the central bank and the separate regulatory agencies for the banking, securities and insurance sectors when it comes to policing shadow-banking activities. China’s central bank and other top financial regulators didn’t respond to requests for comment on the new rules or on the regulators’ efforts to rein in shadow banking.

A split among regulators is not uncommon. In many countries agencies have different agendas and influences. In the U.S., banking regulators were criticized for lax oversight before the financial crisis, but in that case, the crisis was likely made worse because the central bank also failed to aggressively rein in lending.

In the latest cash crunch last month, the weighted average of the seven-day repurchase agreement rate, a benchmark of interbank borrowing costs, on Dec. 23 soared to 8.94%, the highest level since June 21, when it reached 9.29%.

Higher interest rates limit the growth of shadow banking because banks typically need to raise short-term cash to repay long-term debt by installments. As short-term funding costs rise, it would make it less profitable and potentially riskier to make loans using shadow banks.

The funding squeeze didn’t ease until the PBOC assured markets that it had injected funds into the financial system via both open and covert liquidity operations.

While the PBOC has been criticized for slamming on the brakes too hard and risking choking off the banking sector and hurting the broad economy, analysts say the conspicuous inaction by other regulators since the summer cash crunch weakened the effectiveness of the central bank’s efforts.

Shadow banking has thrived in China in the last three years as cash-stricken local governments and companies looked for alternative sources of funding after Beijing phased out a massive lending binge during the global financial crisis.

From 2010 to 2012—when traditional banks scaled back lending—shadow lenders doubled their outstanding loans to 36 trillion yuan ($5.95 trillion), J.P. Morgan ChaseJPM +0.58% has estimated. Critics said many of the loans went to risky borrowers who were counting on rising property prices to pay back their debts. These factors led to comparisons with the U.S. subprime lending crisis, where risky loans to stretched borrowers were often issued based on rising home prices. When the market fell, defaults soared, helping to set off the global financial crisis.

The China Banking Regulatory Commission, the country’s bank regulator, has done less than the central bank to rein in lending. Its latest move occurred in March when it issued rules that required banks to clearly link wealth-management products with specific assets. It also contained largely technical details requiring banks to disclose who will ultimately use the funds and for what purpose, and that each product must be audited.

Lenders have been able to get around these rules by, among other things, making it seem like they are dealing with high-quality borrowers when instead the loans are going to riskier borrowers such as cash-strapped property developers.

“The CBRC has been trying to rein in the situation but when there are measures, there will be countermeasures,” said Yu Shao, chief economist at Orient Securities, referring to efforts by banks to take advantage of loopholes or bypass such regulations.

The China Securities Regulatory Commission, which regulates markets and brokers, will also likely gain more responsibility under the new rules. This is because China’s asset-management companies and securities firms can also issue wealth-management products, and their activities fall under the CSRC’s jurisdiction.