Shadow banking has made quite a mess and there is no easy way out

Updated: Saturday May 31, 2014 MYT 8:02:51 AM

Shadow banking has made quite a mess and there is no easy way out

THE lure of shadow banking is ever present.

Bank of England governor Mark Carney points to shadow banking in emerging markets as the greatest danger to the world economy.

That’s serious. Indeed, I receive regular requests to unravel this phenomenon and why it creates such an all-round “con-attitude” every time the concept surfaces.

Why did it evolve? How large and pervasive is it? Will it lead to instability and precipitate a systemic crisis? One thing is certain; its operations are not necessarily shadowy; it’s global, it’s huge, it’s fast-moving, it’s popular but it’s poorly understood. It can be a powerful tool for good, but if badly managed, can be explosive.

Some definitions to clear the air.

Shadow banking – defined by the Financial Stability Board or FSB (UK’s watchdog to pre-empt financial crises) as lending by other than the regulated banking system.

In most countries, banks are the only authorised depository of savings with last-resort support by the central bank to stabilise the impact of their lending. In return, they are subject to lots of restrictive rules and regulations.

But monies can and do bypass the banks from savers directly to investors.

Viewed broadly, shadow banking includes any bank-like activity undertaken but not regulated, including via mobile payment systems by, for example, Vodafone or Alibaba’s Alipay; technology-based bond trading platforms; investment products sold by Chinese trusts and Black Rock.

Academics’ usage is narrower: ie forms of credit that closely track what regulated banks do, eg direct lending, private equity, investment funds, money and bond markets.

But many bankers do regard any encroachment on their business as shadow banking.

Structured investment vehicle (SIV) – a legal entity created by banks to sell loans repackaged as bonds. When loans go sour, banks are pulled down.

Money market funds – attract spare short term cash of firms and individuals because they give a high return and are deemed risk-free; once they realise these are not (because of poor liquidity management), they are prone to runs.

Chinese shadow banking – encompasses a huge network of lending outside formal channels and beyond the reach of regulators, such as trusts, leasing, business-to-business lending, credit guarantee outfits and money market funds, including on-line finance platforms, pawnshops and micro-credit.

This vast volume of shadow banking activity was valued at US$4.4 trillion at end-2012 by the Chinese Academy of Social Sciences, or about one-half of China’s GDP. It accounted for 1/3 of new social lending in 2013. That’s huge by any standard.

Peer-to-peer (P2P) lenders – a series of websites that directly match savers with borrowers, usually via online auctions. Some platforms even slice, dice and package the loans. This business is exploding globally. Value of loans chaperoned by, for example, UK’s Lenders Club and Prosper (the two biggest with 98% market-share) has doubled yearly since its launch in 2007; its total exceeds US$5bil today. Their success is based mainly on marketing oomph.

Trust beneficiary rights products (TBRs) – banks set-up firms to buy loans from a trust; they then sell the income-flow rights from the loans to other banks, creating TBRs.

This gives the illusion that the corporate loans are “safer”, being lending between banks – they bypass regulatory requirements.

Entrusted loans – involve cash-rich companies (mainly well-known state owned enterprises – SOEs) lending to firms with poor credit-standing using banks as intermediaries to get around regulations preventing such lending, exposing the banks to yet more risks. Such loans have become increasingly popular; they have risen sharply in Q1’14.

Market niche

FSB estimates that shadow banking accounts for about one quarter of global finance. I think more. Shadow banks (SBs) proliferated because US and European banks came out of the recent financial crisis battered, bruised and beset with heavy regulation, high capital requirements and endless legal battles. They retrenched and became risk adverse – cutting credit and down-sizing operations. SBs moved in to fill the gap. Orthodox banks faced two real problems: (i) maturity mismatch (borrowing short and lending long); and (ii) high leverage (building larger credit positions with minimum capital exposure).

So they got into trouble and taxpayers had to bail them out because governments guaranteed deposits, and are just too frightened to let big banks fail lest they bring about systemic failure and deep recession. But growing economies need a consistent flow of credit. So, SBs move in.

This should make on paper the financial system safer. Ironically, SBs are by definition unregulated. As such, once they really proliferate, they can be just as dangerous and then, become unstable. So we are back to square-one.

The real question: how to make SBs safe? No one knows for sure. But one thing is clear. Even Jamie Dimon (JP Morgan Chase CEO – world’s second largest bank by value) acknowledges that SBs have become a real competitor which is a boon to consumers.

Like it or not, banks operate in a changing environment where the boundary lines are blurring and orthodox banks, with stricter rules and capital requirements, will have to compete for turf with non-banks especially SBs.

The outcome should be lower pricing and better services for their clients. To the extent that SBs can make the financial system safer, regulators should encourage the evolution of certain SBs to help widen access to social credit, for the benefit of both consumers and the economy as a whole.

These desirable effects can be achieved by preventing the resurgence of the forms of SBs that brought about the last crisis. What’s certain is that they should not be disguised as appendages of banks. Not ever again.

At the recent Fudan University Shanghai Symposium, I drew attention that whether we like it or not SBs are today a force to be reckoned with.

Many of them are respectable; others less so because of their blatant attempts to side-step the many rules about how much banks can lend to which companies and at what rates. Indeed, China’s concern is centered on trusts.

They offer savers, frustrated by the low caps placed on bank deposits, returns up to 10%. They on-lend at much, much higher rates to firms with poor access to banks because of their low credit standing or they are in frothy industries (property or steel or coal) where regulators have judged to be “over-invested”, so banks are “curbed” from lending.

With the economy slackening, several trust products have since defaulted (eg China Credit Trust’s “Credit Equals Gold No 1 Trust Product” sold US$500mil through big banks), although most investors have got their money back, one way or another. I am told more than US$400bil worth of trust products will mature this year.

Regulators now worry that investors will lose faith in trusts, prompting a run which may, in turn, spark a crisis of confidence in the face of overall economic slowdown.

Ironically, trusts are regulated by the same agency CBRC (China Banking Regulatory Commission) that supervises banks. So trusts are now subject to tightening oversight, forcing monies to flow to less closely watched but weaker SBs.

Fear of a downward spiral in which pricking the property bubble or the collapse of commodity prices can lead to panic among SBs, pushing housing and commodity prices and overall growth down further. Something has to be done.

What then, are we to do?

The dilemma for China’s regulators is that while the impact of manoeuvres by SBs can spread to the real economy, many trust loans are secured with decent enough collateral, mainly property so that losses should be manageable. The problem is timely access to liquidity. The real threat remains moving too forcefully by regulators to rein in shadow lending in the face of default, accidentally precipitating a run on SBs.

The irony is that China can really benefit from the activities by certain forms of shadow banking, especially securitisation.

After all, China needs to develop deep capital markets and here SBs can be managed to make finance safer. Unfortunately shadow banking has already made quite a mess.

Regulators have so far moved warily and, in my view, allowing an occasional minor real default can do some good.

Calibrating their activities is tricky. Realistically, there is no easy way out of this mess.

Former banker, Tan Sri Lin See-Yan is a Harvard-educated economist and a British Chartered Scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email:


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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