PowerPoint Presentation

Chinese shadow bankingAcademic Group 11Gaurav Kukreja | Malvika Pradhan | Shounak Mitra | Suyash Singhal | Vivek Ostwal Jain Credit intermediation involving entities and activities outside the regular banking system.- Financial Stability Board (FSB)Credit intermediation involving entities and activities outside the regular banking system that serves to provide liquidity and credit transformation and which could potentially be a source of systemic risk or regulatory arbitrage.- Peoples Bank of China (PBOC

Shadow banking THE what & THE so whatWHAT IS SHADOW BANKINGRegulatory Arbitrage A practice whereby firms capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulationNATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

CAUSE OF RISE OF SHADOW BANKING Banks completely dominated Chinas credit system from the start of the era of reform and opening up in 1978 but faced the following issues - * Micromanagement of lendingBank loans were made on the basis of direction from important government or party officials to avoid or limit lending to certain industriesControl by Peoples Bank of China overMicromanaged Lending*NATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

NATURE OF SHADOW BANKING IN CHINAEntrusted Loans Loans made by forms in the non-financial economy that are run through banks for legal reasons, but with the banks indemnified from the credit risk of the borrower by the non-financial firm.Bankers Acceptances Certificates issued by banks that promise unconditionally to make a future payment, backed in part by a deposit from the party desiring the Acceptance.Microfinance Companies Separately regulated financial firms that are licensed to lend in small amounts.Financial Leasing Leasing that is not already on a bank or trust balance sheet and is not a short-term operating lease.Guarantees Providing financial guarantees can transfer credit risk to guarantee firm. Guarantee firms have also branched out to make direct loans.Wealth Management Products Investment products that provide a return based on the performance of a pool of underlying assets. Trust Beneficiary Rights A derivative transaction. Purchaser of the TBR receives returns accruing to a trust. Banks use TBRs to keep the economic benefits of a loan without showing it in their Balance Sheets.Unofficial Lenders Pawn shops are important lenders to small businesses and households.Inter-bank Market Substitute for formal deposits. Participants are not banks, but large corporations using subsidiaries to participate. They lend money to banks in deposit like arrangements without being subject to caps on deposit rates.Trust Loans and Leases Financial transactions undertaken by trust companies.NATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

SIZE OF SHADOW BANKING IN CHINA

Range of estimates From RMB 5 trillion to RMB 46 trillion RMB 25 trillion at the end of 2013 43% of Chinas GDPNATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

5TOTAL SOCIAL FINANCING

Level of TSF provided by the Peoples Bank of China. Started from 2002 when banks ceased to be the only finance sources. Although it includes non-credit financial activities like equity raising and venture capital, these components are very small. Shadow banking comprises most of the non-bank TSF activities.NATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

Wealth management products (wmp)WMPS are investment products marketed by banks as higher yielding alternatives to savings accounts.WMPs essentially circumvent Chinas tight control of interest rates by rewarding investors higher returns than deposit rates.How do they work?NATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

1. Banks receive loans from investors.2. Funds are given to trust companies which create the WMP.3. Banks market WMPs for a commission.4. WMPs pool funds with a short investment horizon (eg five days) and invest them in longer duration assets to arbitrage the difference in returns.5. Banks dont hold these loans on their balance sheets or set aside capital against their potential defaults (0% reserve requirement).6. The trust then invests the money gathered through a WMP in a given company

Why invest?In China, interests on deposits are highly regulated.The return on deposits after being adjusted for inflation is extremely low.WMPs give annualised returns o>= 5% vs. 0.8% from bank accounts.

Wealth management products (wmp)NATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

RisksHigh risk investmentsTo give high returns over a short period funds are invested in high risk projects

Close Ties to Property MarketFunds mainly invested in property.Property prices in China undergoing a correction from 2014A 10-15% fall in prices can reduce WMPs value by 20%

Similar to a Ponzi Scheme

Money Multiplier Effect0% reserve requirement for WMPs creates a higher money multiplier effect than for loans.Credit grows at a higher-than-normal multiplier

WMP spread can be a way to determine the real deposit rate. The products can be a form of healthy financial innovation.DefaultsDateShort Term Return PromisedBankAmount (RMB)Nov 25, 20127-11%Huaxia Bank200 millionJuly 201315%Industrial & Commercial Bank of China3 billionFebruary 2015CITIC Securities7 million

Regulation of WMPsNATURE OF SHADOW BANKINGINTRODUCTIONCAUSE OF RISE OF SHADOW BANKINGSIZE OF SHADOW BANKINGTOTAL SOCIAL FINANCEWEALTH MANAGEMENT PRODUCTS

Chinese regulators are trying to reign in this industry giving it more structure and imposing legislation, however, banks find ways to circumvent laws. YearAction by China Banking Regulatory CommissionBanks Response2009Banks could not deal directly with trust companiesRestructured their products through security companies2013Split WMPs in standard and nonstandard (most high risk) products. Outstanding non standard WMP balance limited to 35%Assets to be managed allowing regulators to see what each consisted ofNon-standard products sold to a third party and then buying them back, bringing them into the standard category2014WMPs to invest in domestic bond and stock marketsBanks also have to set aside funds to safeguard against potential risksNo response yetShadow banking has come about due to extremely restrictive monetary regulations. The influence of WMPs can be reduced only if the tight monetary controls are lessened since they are a source of financing for a large part of the economy.

Thank you