China’s banks are feeding unwanted assets into the country’s “shadow banking system” on an unprecedented scale, reinforcing suspicions that bank balance sheets reflect only a fraction of the actual credit risk lurking in the financial system.

Banks’ latest earnings reports only added to concerns. Despite the slowest economic growth in 13 years in 2012, the banking system’s official non-performing loan (NPL) ratio actually declined, renewing a debate about how reliable those figures are.

But the key question is no longer how much risk banks are carrying. Rather, it’s how many risky loans have been shifted to the lightly regulated shadow banking institutions – mainly trust companies, brokerages and insurance companies.

The risk to the overall financial system is not clear, because of insufficient data about the quality of credit in the shadow banking sector.

Trust companies and brokerages probably aren’t buying many bad loans directly, analysts and industry executives say, but they have become a vital source of credit, allowing banks to arrange off-balance-sheet refinancing for maturing loans that risky borrowers can not repay from their internal cash flow.

Without these institutions, the amount of NPLs might have been much higher, though no one is quite sure how high.

Trust assets increased 55 percent in 2012 to 7.5 trillion yuan ($1.21 trillion), according to the China Trustee Association, while funds entrusted to brokerages by banks soared more than fivefold to 1.61 trillion yuan.

“There is absolutely an impact on NPL figures from the ability to offload stuff through these channels,” said Charlene Chu, China banks analyst for Fitch Ratings.

Trust companies sell wealth management products (WMP) to raise funds so they can purchase loans that banks want off their books. WMPs are then marketed through bank branches as a higher-yielding alternative to traditional bank deposits.

“These (bank) loans are not being repaid by the borrowers; they’re being repaid by investors in the (wealth management) products. So we really can’t see what the true corporate repayment rate is,” said Chu.

In 2010 and 2011, analysts began fretting about the large volume of loans to local governments and state firms – doled out as part of China’s massive economic stimulus plan from 2008 to 2010 – that were due to mature in 2012. But the wave of defaults never materialized, in large part because banks, working with trusts and brokerages, provided fresh funds to enable borrowers to refinance their debt.

Industry executives say at least half of trust company assets and 80 percent of brokerages’ entrusted funds are related to so-called “passageway business.”

In passageway deals, trusts and brokerages cooperate with banks to act as passive reservoirs for loans that banks originate but cannot keep on their own balance sheets without running afoul of lending quotas, capital adequacy requirements, and loan-to-deposit ratios.

The loans the trust companies buy from the banks, along with other assets such as corporate bonds and money market instruments, stand behind the wealth management products. If borrowers default on the loans, the investors in the wealth products – not the trust companies – generally bear the risk.

To be sure, not all the loans that banks transfer off-balance-sheet are high risk. In fact, “more than half of shadow banking credits in China could have better risk levels than bank loans,” ratings agency S&P wrote in a recent report.

But the agency also warned that banks are particularly keen to dump riskier loans extended to local governments and property developers in order to satisfy banking regulators who have ordered them to restrict exposure to these sectors.

China’s banking regulator said the bad loan ratio for the entire system was 0.95 percent at the end of 2012, down 0.05 percentage points from a year earlier. But that figure only covers on-balance-sheet loans, leaving a huge amount unmonitored.

Ratings agency S&P estimates that outstanding Chinese shadow banking credit totaled $3.7 trillion by the end of 2012, equal to 34 percent of on-balance-sheet loans and 44 percent of GDP.


Even as banking regulators continue to use so-called “window guidance” – ad hoc instructions to banks on how much they should lend – to control the volume of on-balance-sheet loans, the passageway business has so far remained lightly regulated.

That’s because regulators see shadow banking as an experiment in liberalized interest rates and an incubator for risk-based capital allocation and financial innovation.

“Whatever else you might say about it, shadow banking is a market-based financing system. When it comes to midwifing market innovation, right now regulators don’t want to regulate it to death,” said a source close to regulators.

Guo Shuqing, who served until recently as chairman of the China’s Securities Regulatory Commission, was known as a champion of financial innovation. Guo encouraged brokerages to develop asset management as an alternative revenue source amid weakness in their core trading and underwriting businesses.

In reality, however, the passageway business appears to be little more than regulatory arbitrage: shifting lending to institutions not subject to the strict rules that govern banks. Trusts and brokerages add little value beyond providing a passive conduit for banks to remove loans from their balance sheets, collecting a management fee from banks in the process.

“Money with no risk and no responsibility – who wouldn’t want to earn that? Trust companies like doing bank passageway business the most. I just give you three copies of a form, add the company stamp, take the money, and it’s all done,” a senior trust industry executive told Reuters.

“‘What kind of risk control? What kind of due diligence?’ If you ask too many questions, the guy (from the bank) won’t work with you. He’ll find someone else,” the executive said.


Insiders also say the loans packaged for sale to trusts and brokerages are granted with less scrutiny than those that remain on balance sheets.

“They don’t share the traditional bank culture – cautious and standardized,” said a risk officer at a large commercial bank, referring to bankers involved with passageway loans.

“It’s a trading-infused style. As long as the product is well received (by investors), it’s all good. They don’t pay enough attention to the fundamentals of the loan.”

Such concerns mirror the criticisms leveled against Western banks in the wake of the financial crisis, when mortgage loan officers often failed to conduct adequate due diligence because they knew the loans would quickly be passed to other investors.

Apart from the desire to promote innovation and market-based reform, regulators have encouraged the rise of shadow banking, in part due to the need to support growth last year, when China’s economy grew at its slowest pace since 1999.

“The entire push behind shadow banking is deeply rooted in the government’s desire for growth,” wrote Dong Tao, China economist at Credit Suisse, in a recent note. “Shadow banking activities have increased because China needs growth, and the banking sector has, to a significant degree, failed in its role of financial intermediary.”

Regulators’ hands-off approach may finally be changing. China’s banking watchdog released new rules that limit the share of “non-standardized credit assets” – loans essentially – to no more than 35 percent of underlying assets for any wealth management product.

If strictly enforced, the new rule could restrict the supply of funds available for off-balance-sheet lending. Instead of investing in loans, wealth management products would have to raise the proportion of funds invested in more liquid assets such as corporate bonds and money market instruments.

($1 = 6.2080 Chinese yuan) (Editing by Ken Wills)

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