Off-the-books bank loans in China create credit risk

Text message solicitations began arriving on the mobile phones of many of China’s wealthy last month, promising access to lucrative wealth management products with yields far above the government’s benchmark savings rate. One message read: “China Merchants Bank will issue a high interest financing product starting from June 28th to 30th. The product will be 90 days with a 5.5% interest rate. Please call us now.”

A day later came another. “Warm reminder: The interest rate of yesterday’s product has been raised to 6 per cent. (Product duration is 90 days). There is limited access to this product. First come first served.”

The offers are not coming from fly-by-night operators but some of China’s biggest banks. They are raising huge pools of cash to finance a relatively new and highly profitable sideline business: lending outside the scrutiny of bank regulators.

The complex way they go about making off-the-balance-sheet loans is at the heart of China’s $6 trillion shadow banking industry, which the government is now trying to tame. Efforts to rein in the dodgy lending practices put stock markets worldwide in a tizzy in late June.

China’s regulators - and a fair number of economists, policymakers and investors - worry that legitimate banks are using lightly regulated wealth management products to repackage old loans and prop up risky companies and projects that might not otherwise be able to borrow money.

Analysts warn that shadow banking is helping fuel the rapid growth of credit in a weakening economy, which could lead to - in a worst-case situation - a series of bank failures.

“This is the biggest uncertainty I’ve seen in my 18 years following the China market,” Dong Tao, an economist at Credit Suisse, said of shadow banking. “You don’t know how banks are deploying capital. And you don’t know the credit risks.”

What banks are doing, analysts say, is pressing customers to shift money from the old, regulated part of their operations - savings deposits - into the new, less regulated part consisting of high-yielding wealth management products that can circumvent government interest rate controls and be used to finance high-interest loans to desperate customers.
China’s leaders are so worried about credit risk that last month the country’s central bank tightened credit in the interbank market, where banks typically go to borrow money from other banks. The move sent short-term interest rates soaring, and for a day at least, created a debilitating credit squeeze. The stock markets in China calmed down last week. But financial institutions are hinting that cash is still hard to come by. Some banks temporarily suspended lending in order to preserve cash, according to Caixin, the Chinese business magazine.

Other banks are raising cash by offering a new slate of wealth management products. Nearly every major Chinese bank sold a short-term wealth management product that had to be completed by the end of June, according to a telephone survey. China Merchants Bank did not respond to requests for an interview.

Many of the investments pay 6 percent annual interest, which is far above the highest savings deposit rate set by bank regulators: 3.3 per cent. Consumers withdraw money from their regular savings account and put it into a wealth management product that promises a much higher rate. “Usually banks will have higher-yielding products at the end of each quarter,” said Wang Yanan, 24, an accountant who works in Shanghai. “If I happen to have money at those moments, I’ll buy some.” Though the products are popular, their disclosure is often poor. Bank employees insist the principal is guaranteed, but contracts for wealth management products are usually vague, simply noting there could be risk. Most offer little detail about where the money will be invested.

Much of the money, analysts say, is lent to property developers and local government financing vehicles, areas that have government officials worried because of an explosion in property development and soaring housing prices. Regulated banks will not make the loans because the borrowers are too risky. So the loans are often made off the balance sheet, and therefore outside the purview of bank regulators, which is why experts call it shadow banking. They are made at higher interest rates, so everyone wins - the borrower, the banks and the investor of the wealth management product - as long as the borrower can repay.

“The banks now have these dark pools of money,” said Joe Zhang, a former investment banker and the author of “Inside China’s Shadow Banking: The Next Subprime Crisis?” He added, “To finance deals they usually have a trust company stand in the middle and simply put their stamp on it. The trust companies get a fee for that but often they do next to nothing. The bank does all the work.”

The explosive growth of wealth management products began about five years ago, enticing Chinese banks, big and small, to engage in shadow banking.

High-risk sectors

By the end of last year, China’s shadow banking activity was valued at $6 trillion, twice the level in 2010, and now equal to 69 per cent of China’s gross domestic product, according to a report released last month by JPMorgan Chase. Now, even state-run banks are doing shadow lending, extending financing to companies in high-risk sectors. Who is responsible for the loans is not always clear, and that’s where everyone starts getting nervous.

“If a wealth management product defaults, who is on the hook?” asked Michael Pettis, a finance professor at Peking University in Beijing and senior associate at the Carnegie Endowment for International Peace. “It’s all very murky. In these things, the banks are technically acting as intermediaries.”

Financial experts worry about the lack of transparency in the market when China’s economy is weakening. They also fret about whether some borrowers have sufficient cash flow to repay their loans. Fitch Ratings, the credit ratings agency, began warning two years ago that “wealth management activity carries unique liquidity and credit risks.” But the lending continued and, indeed, increased.

In a newspaper opinion piece last year, Xiao Gang, then head of the Bank of China, a leading commercial bank, and now the nation’s top securities regulator, referred to shadow banking as “fundamentally a Ponzi scheme.”

The government has so far tolerated shadow banking because getting rid of it is all but impossible, analysts say. Wealthy customers have grown accustomed to getting better returns, and a large segment of the economy is desperate for capital and cannot easily gain access to regular bank loans, largely because of government restrictions. But they are willing to pay the shadow banks 9, 10, even 15 percent interest.

And to make that possible, China’s banks are raising pools of capital and creating increasingly complex financial instruments with outside institutions to make off-the-books loans to those willing to pay a premium. Perhaps the biggest worry though is that this booming business could be undone by a major business failure that forces bank customers to suffer losses.

“This is a major problem,” said Ding Shuang, a Citigroup analyst based in Hong Kong. “Many of these are just three months, and they need to be rolled over. So if there’s a default that could change things. This is a problem regulators are very aware of.”