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Many people are worried about shadow banking, finance which exists outside of regulated banks, in China. Fitch, the rating agency, has raised alarms about its growing presence in the country and critics cite countless examples of seemingly risky and irresponsible lending in warning that a financial crisis looms.  

Whether shadow banking really is a worrying danger or merely evidence of a maturing financial system depends on its magnitude and risk profile. Various estimates indicate that the sector has doubled its share of new credit from about 20 per cent in 2008 to 40 per cent by June 2013, at which point it accounted for roughly a quarter of the outstanding credit stock.  

Meanings of shadow banking vary but a useful definition for risk assessment purposes would include only systemically important activities linked to the formal banking sector, such as wealth management products, bankers’ acceptances, trust products and entrust loans while omitting marginal forms of lending. Estimates that are in line with this definition place shadow banking at about 50-60 per cent of GDP or about 25-30 per cent of banking assets. The Financial Stability Board estimates that shadow banking represents 117 per cent of GDP and 52 per cent of banking assets worldwide, more than double their respective levels in China, where the concerns are more about the rapid growth of the sector rather than its overall size.  

While such numbers may make for good headlines, they are not particularly helpful for assessing risks. Broadly, there are two ways in which shadow banking can exacerbate risks. The first is by lending to financially weak borrowers. For this to become a serious issue, such lending must also be large relative to the size of the economy. The second form of risk comes from being strongly interconnected with the more formal banking system.  

Some forms of shadow banking such as entrust loans and bankers’ acceptances are relatively less risky. The former because lending is generally between related companies and asymmetries of information are lower. The latter because they require more documentation and are often collateralised.  

But there is a genuine concern with trust companies. Unlike banks, trusts are prohibited from taking deposits but can make loans, purchase securities or invest in private equity which they then sell on to investors in the form of “trust products” with enticing interest rates.  

There are two primary concerns about trusts. One is outdated and the other is overstated. The outdated concern is that trusts are just a way for banks to circumvent quantitative or sector limits on their lending by moving loans off of their balance sheets. Recent regulations have restricted the scope and magnitude of such activities to just 20 per cent of trust assets. The more pertinent concern is that trusts are disproportionately invested in risky sectors such as real estate and raw materials. This may be true but trust assets are not as concentrated as is often perceived: less than 40 per cent of trust assets are invested in these areas and this is declining. However, credit risks are generally higher for trusts than banks because they serve financially weaker businesses. Thus defaults and their spillover impact are an issue.  

But bank-trust cooperation has been scaled back and with tightening of regulations, potential spillover effects have declined. The entire trust sector amounts to less than 8 per cent of bank assets, only a small portion of which will default. And only a small portion of those losses will likely be absorbed by the banks. Moreover, if investors lose confidence in the trust market, their money will simply flow back into bank deposits because of China’s capital controls. Thus a loss of confidence in shadow banking will, if anything, increase liquidity and reduce the cost of capital for banks.  

The final component of shadow banking are wealth management products which are often confused for a type of deposit. These are quite distinct from the other forms of shadow banking as they do not involve any direct credit extension. They are a distribution channel for investing in a range of existing assets such as bonds and trust products and in some cases equity. This shifts the ownership of existing debt rather than creating new debt. However, while they may not have introduced additional credit risk, they have generated a variety of other vulnerabilities.  

What sets wealth management products apart is their intrinsic connection to the banks, creating spillover risks. Many analysts allege that banks are likely to bail-out failing wealth management products to mitigate reputational damage. To reduce risks, some banks have pooled funds from multiple products but this reduces transparency about their underlying quality. In response, banks are now required to restrict the share of nontraditional credit assets in their wealth management portfolio and all product must be explicitly linked to an underlying asset.  

Overall, the exposure of the traditional banking system to risky shadow banking activities is much less than the alarmists have implied. The real concerns are more narrowly concentrated in the activities of trust companies and banks’ wealth management products, although even here the risks are often exaggerated. These two activities amount to 36 per cent of GDP or about 15 per cent of bank assets. This, however, is an overstatement of the size of these activities as there is double-counting of wealth management products’ investment in trust products, which could account for as much as 30 per cent of their assets. Further, over half of wealth management product investments are in safe interbank assets and government and financial bonds.  

Ultimately the much-hyped, high-risk components of the shadow banking system are unlikely to exceed 15 per cent of GDP or about 6 per cent of bank assets. It would take truly disastrous performance and lackadaisical crisis management by Beijing for these assets to pose a serious threat to the stability of China’s banking system.  

The author is a senior associate at the Carnegie Endowment and a former World Bank country director for China  本文作者是卡内基国际和平基金会(Carnegie Endowment)高级研究员、世界银行(World Bank)前中国业务局局长