On Monday, I discussed the major bubble crisis in China. I’ve mentioned the term Shadow Banking. This new banking term caught my attention – is shadow banking legal? What is Shadow Banking anyways? And most importantly, how can Shadow Banking affect your portfolio?
With a name like this, it’s hard to think shadow banking is good for the economy. From my understanding, shadow banking is like steroids; it boosts your performance and exacts a toll to pay later at a critical price for your excesses.
Shadow Banking and the 2008 Crisis
The term “shadow bank” was coined by economist Paul McCulley in a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming (source IMF.ORG).
A short explanation would be a parallel banking system that doesn’t follow traditional bank regulations. This is how banks were able to literally package their mortgages into commercial paper backed securities and sell them in the shadow banking system in 2008. Those high risks mortgages were then taken off the banks’ balance sheets to be sold on the market. You know how this story ended… with blood on the street.
Imagine that: something similar and probably bigger is happening in China right now…
How Shadow Banking works in China
This is a very well designed system where Chinese banks pretty much ignore any classic banking rules. In a classic model, here’s what is happening with your money:
As the process continues, there is less and less money available to lend from the Bank. This is normal as Gov’t laws force banks to keep a specific minimum of cash in their institution to cover for bad loans or to fund any withdrawals from its clients.
But right now, the bank is not directly lending money. Through Wealth Management Products (WMP), it can invest 100% of the deposits into these “funds” that are held and managed by an outside trust. The Wealth Management Product Trust usually fund riskier projects to make a higher yield. So the cycle looks like this:
The system looks awesome as it injects more liquidity into the economy and the WMPs offer higher yield than banks. For example, a WMP can offer as high as 10% return while a normal investment within the bank will generate 3%. This sounds a lot like skipping the money market fund to invest in commercial paper backed by securities with a higher rate of return…
And the problem is similar too: since the money is managed by a trust that is owned by the bank, you can’t have access to what is inside and how risky investments are. This is where we start walking through the fog. Some say it represents 45% of the Chinese banking system, some say it is as big as $1,785B USD…
As was the case with commercial paper, as long as the wheel is turning, it’s all good. But when the wheel hits bumpy roads where buildings are built without tenants, the high yield promised by the WMP is not delivered. This happened in January when the biggest bank in China, the Commercial Bank of China (ICBC), promised a 10% return on an investment in a product called Credit Equals Gold #1 to 700 clients. The money was invested in a coal producer which went bankrupt. There was no way the bank could pay the 10% return. But since we don’t live in a capitalist country, a “mysterious” investor came at last minute and injected enough money to cover for the mess.
The Chinese Gov’t Will Cover Everything… Will They?
There are some people who aren’t too worried about the situation. They claim China has the largest money reserve in the world (estimated at $3,821B USD). This represents twice the Chinese shadow banking system. We can then hope China will cover all the mess.
But I don’t agree that China will always cover for hundreds of buildings left abandoned in these ghost cities. Money isn’t free, even for the Chinese. The fact we don’t know exactly what is going on and that we can’t get clear answers is the proof that something is wrong. It reminds me too much of the 2008 crisis when nobody could tell us where the money had gone. But one thing is for sure…. It WAS GONE.
It appears shadow banking takes the idea of fractional reserve banking to a whole new level 😕 I agree that China’s risky lending behavior cannot go on for much longer without dramatic economic and social ramifications. Money was created out of thin air and it could just as easily disappear into thin air. Maybe nobody in 2008 could say where the money had gone because they didn’t want to face reality, which is that money starts to disappear when liquidity dries up, because both loan paybacks and loan defaults shrink the money supply. Excess lending and cheap rates are what’s keeping the economy afloat today. But eventually not even China could prop up their shadow economy with government intervention. What will the world do then?
That’s a very good question. A fast answer would be to look at Japan’s economy for the past 20 years…