China: Financial System Vulnerabilities—Shadow Exposures, Funding, and Risk Transmission1
The proliferation of "shadow" credit products and growing reliance on short-term, wholesale funding could pose substantial risk. Oversight should be enhanced commensurately.
Recent supervisory action seems to close the major regulatory gaps but will need to be implemented strongly and should ensure that losses on existing shadow credit holdings are promptly recognized.
On funding, liquidity frameworks should be reviewed, tightening of leverage mechanisms in the interbank market considered, and the overall shift toward wholesale and interbank sources closely monitored with a view to imposing more measures if recent trends continue.
1. The proliferation of "shadow" credit products and growing reliance on short-term, wholesale funding, could pose substantial risks. Recent work by the Fund and others suggest that borrower solvency is deteriorating and that potential defaults on corporate loans by ‘at-risk’ borrowers could potentially imply significant costs (e.g., the April 2016 Global Financial Stability Report). But the process of loss realization on loans is likely to be gradual and the system has mechanisms, such as state backstops, to prevent loan deterioration from rapidly metastasizing. A possibly greater risk to stability may reside in the potential for defaults on widely-held "shadow products" to trigger risk-aversion that results in the withdrawal of liquidity from short-tenor investments in high-risk borrowers. This risk is intensified by financial institutions’ own increasing reliance on short-term wholesale (including interbank) funding, a structure potentially susceptible to rapid risk transmission and destabilizing liquidity events.
2. "Shadow credit products" are large and growing rapidly. Shadow credit products are investment instruments, mainly with loans or other credit as underlying assets, structured by trust or securities companies, or their asset management subsidiaries. The volume of these products grew by 48 percent in 2015, to RMB 40 trillion, equivalent to 40 percent of banks’ corporate loans and 58 percent of GDP.
3. About half of shadow credit products appear to pose elevated risk of default and loss. Some shadow products appear benign; but others appear to contain significantly higher default risk and loss potential than banks’ corporate loan portfolios. These high-risk products offer yields of 11−14 percent, compared with 6 percent on loans and 3−4 percent on bonds. Those whose underlying assets are ‘nonstandard credit assets’ (NSCA)—untradeable debt, typically loans—are probably of lowest quality; and shadow products based on equities are also risky. RMB 19 trillion, nearly half of total shadow products, have either NSCA or equities as underlying and appear high-risk relative to corporate loans.
4. Banks’ on-balance sheet exposures to shadow products are large and growing fast. At end-2015, banks held RMB 15.2tn2 of shadow products—equivalent to 8 percent of banks’ assets and 92 percent of capital buffers, and up 58 percent year-on-year for listed banks. Because these positions appear to be motivated in part by some banks’ practice of repacking deteriorating loans into investment securities to avoid recognizing and providing for nonperforming loans (NPLs), banks’ exposures are likely skewed toward the riskier products (those with NSCA as underlying asset). The "big four" banks have small exposures, but several other listed banks and the unlisted in aggregate have exposures that are several times their capital.
5. Shadow products also can generate transmission risks that are potentially less manageable than loan losses. Where shadow products differ qualitatively from high-risk loans is in their greater power to transmit risk across the financial system. Of greatest concern are holdings by investors who have little ability or incentive to continue supporting market liquidity in the face of shocks or deterioration in credit conditions. Vulnerable segments include ‘collective’ instruments (RMB 10.9 trillion at end-2015); and holdings by nonbank financial institutions (particularly investment funds), corporates and individuals. Sizing the ‘high-transmission’ segment of the shadow system is difficult; but it appears sufficient to potentially catalyze significant liquidity challenges.
6. Rapid asset growth has increased banks’ and other financial institutions’ reliance on wholesale funding. From 2010 to 2015, total financial system assets grew by 5½ times more than GDP, twice as much as total social financing and three times as much as loans. Thus while the banking system loan-deposit ratio remained stable, total assets have grown much faster than deposits. Financial system assets relative to the stable bank deposit funding in the system rose from 163 percent in 2010 to 193 percent in 2015; and for banks, from 130 to 143 percent. The gap has been funded from wholesale sources; staff estimate that wholesale sources as a percent of total bank funding essentially doubled, from 15 to 34 percent, over the period 2013 to 2015. (Counting banks’ principal-protected wealth management products as quasi-deposits would lower wholesale funding dependence to 30 percent at end-2015.) This wholesale funding is potentially less stable than deposits.
7. The interbank market, which accounts for about half of bank wholesale funding, may become a stress transmitter in the event of a shock. Banks source about 16 percent of their total funding from the interbank market, up from 8 percent at the end of 2010. Financial institutions, including banks, are in aggregate net borrowers in the interbank market. The funding providers are investment vehicles, mostly structured as 'wealth management products’, by which trust and fund management companies source funds (mostly less than three months in tenor) from yield-seeking investors. The interbank market is also shifting toward riskier practices—for example, increasing use of 'pledged' repurchase agreement contracts to increase leverage and investment returns.
8. The rapid expansion in the size, interconnectedness, and complexity of the financial system calls for a commensurate increase and coordination in oversight. The broad direction should be to a more holistic, system-wide approach, with harmonized treatment of similar institutions and products, and enhanced supervisory coordination and information sharing. The authorities are progressing in this regard, though unaddressed issues and implementation challenges remain.
9. Recent steps to close regulatory arbitrage incentives for banks to hold shadow products are welcome, though implementation challenges remain. The rapid growth of banks’ on-balance sheet exposures to shadow products seems intended in part to exploit regulatory loopholes. Transferring deteriorating loans into securitized packages, much of which ends up on banks’ balance sheets, allowed banks to avoid recognizing these exposures as NPLs, taking loan-loss provision charges to earnings, and including the loans in their loan-to-deposit ratios. The recently published Document 82 constructively criticizes the opaque and nonstandard transactions structures and weak prudential supervision of capital adequacy and loss provisioning that enable these practices. More importantly, it appears to close the major regulatory arbitrage opportunities and should limit banks’ ability to engage in these transactions in future—a significant positive development if implemented strongly. However, it is not clear that the new regulation compels recognition of impaired assets in existing positions. For some banks, immediate recognition of asset impairment in the investment receivables book would seem to imply substantial provision charges.
10. The authorities should consider measures to strengthen financial institutions’ liquidity and the robustness of wholesale funding structures. A few specific suggestions:
There are international frameworks for managing liquidity risk, and China has introduced Liquidity Coverage Ratio (LCR) regulation for banks. Nonetheless, evidence presented earlier of increasing funding risk suggests that the implementation of the LCR framework may require review, with focus perhaps on the designation of High-Quality Liquid Assets (HQLA) and the 'outflow' assumptions applied to wholesale and interbank elements of the banks’ funding.
The authorities may wish to revisit and tighten the mechanisms available for participants to generate leverage within the interbank system. This might include stricter limitations on the use of pledged repo to achieve leverage. In addition, the authorities should reconsider allowing the use of relatively low-quality assets like Trust Beneficiary Rights as collateral for repurchase agreements.
Finally, the overall shift of funding toward wholesale and interbank sources should be monitored; and continued increases in this direction may merit consideration of more comprehensive frameworks to limit liquidity risk.
International Monetary Fund, 2016, Global Financial Stability Report (Washington, April).
International Monetary Fund, 2016, Global Financial Stability Report (Washington, April).)| false