China’s massive stimulus in the wake of the Global Crisis was followed by contractionary monetary policy between 2010 and 2013. The resulting fall of bank loans and deposits was accompanied by a rapid rise of ‘shadow banking’, which partly offset the decline of bank loans and appeared to help stabilise output growth (Figures 1 and 2).
Figure 1. Growth rates (year over year) of monetary aggregates, bank loans, and bank deposits
Sources: PBC and CEIC
Figure 2. M2 growth and the rise of shadow banking and entrusted lending (in trillion RMB)
Notes: Entrusted lending is one principal component of shadow banking. Both shadow banking and entrusted lending are newly originated loans. The share of entrusted loans is the share of the entrusted-lending amount in the sum of entrusted lending and bank lending, where bank lending is measured by newly originated bank loans as well.
Sources: PBC and CEIC
But the central policy question is: What were the consequences of China’s rising shadow loans on China’s banking system and, eventually, on China’s real economy?
What role did banks play in the rise of shadow loans?
Chinese shadow loans consist of three major components:
- Trust loans,
- Bank acceptances, and
- Entrusted loans.
It is entrusted lending that marks a unique feature of China’s shadow banking and thus is a focus of our analysis here.
Entrusted loans are lending activities between non-financial firms with commercial banks or non-bank financial companies acting as trustees (middlemen). The 2000 PBC regulation made it mandatory for a financial institution to facilitate a loan transaction between two non-financial firms. The purpose was to encourage financial institutions to use their specialty in monitoring and screening technology to help curtail non-performing or risky loans; financial institutions would receive only fees for their facilitating services.
The volume of newly originated entrusted loans reached its climax in 2013, accounting for nearly 49% of total shadow banking. Entrusted lending has since become the second largest financing source after bank lending.
On paper, this arrangement was off banks’ balance sheets and appeared to create a financial market not provided by banks. Thus, the existing literature has focused on analysing certain detailed features of this alternative financing channel. Qian and Li (2013) provide an analysis of entrusted lending as an alternative funding to bank loans when borrowing and lending firms had an affiliated relationship (i.e., both firms belonged to the same conglomerate). Allen et al. (2015) explore which types of lending firms were inclined to make entrusted lending as well as their motives in making affiliated and unaffiliated loans. He et al. (2015) investigate how stock prices of borrowing and lending firms reacted to an announcement of loan transactions.
None of these studies, however, discusses the consequences of rising entrusted loans on the banking system or on the real economy. This important issue has been informally discussed in the media (e.g. Yap 2015). In a recent paper (Chen et al. 2016), we offer an in-depth formal analysis.
- We argue that banks played a prominent role in the rapid rise of entrusted lending during the period of monetary tightening.
We build this argument by first constructing a comprehensive transaction-based micro dataset from 2007 to 2013 and then conducting robust empirical analysis. Our estimation indicates that a one percentage point decline in M2 money supply growth increased the amount of entrusted lending through banks by 4.2%. In contrast, there is no evidence that entrusted lending through non-bank trustees reacted to monetary tightening. Among commercial banks, we find that non-state banks played a much more important role than state-owned banks. In particular, a one percentage point decline in M2 growth increased the amount of entrusted lending through non-state banks by more than 5%, while the increase through state-owned banks was only 2.7%.
China’s two well-intended regulatory policies and institutional asymmetry
Among a myriad of banking regulations, we identify two specific ones that created an incentive for non-state banks to play an active role in entrusted lending.
- The first is the safe-loan law enacted during the monetary tightening period by the Chinese Banking Regulatory Commission (CBRC), which prevented banks from making loans to the risky industry.
The risky industry is identified by China’s Ministry of Industry and Information Technology as consisting of the real estate industry and 18 overcapacity industries such as the steel, infrastructure, and petroleum sectors. At the time when monetary policy began to tighten in 2010, the CBRC took concrete steps to curtail expansion of bank lending to the risky industry.
- The second regulation, enacted by the PBC in 1994, was a 75% ceiling imposed on the ratio of bank loans to bank deposits (the loan-to-deposit ratio or the LDR ratio).
This regulation was not enforced until the monetary tightening period. As M2 growth began to slow down in late 2009, banks became more vulnerable to deposit withdrawal risks caused by monetary tightening. To meet the loan-to-deposit ratio regulation, state-owned large banks, with branches in almost every corner of China, had advantages of attracting deposits from state-owned non-financial firms to weather deposit shortages with little cost. In contrast, non-state banks had relationships largely with small firms and whose customer base for deposits was not nearly as broad and stable. Consequently, when the deposit monitoring time came near, non-state banks had to face higher funding costs for additional deposits, a phenomenon the CBRC called ‘last-minute rush’ (chongshidian in Chinese).
Regulatory arbitrage and banks’ risk-taking behaviour
To overcome disadvantages associated with these regulatory costs, non-state banks had incentives to exploit regulatory arbitrage by making risky investment that did not show up on loan books. The central government’s strategic plan since 1997 has been to promote growth of heavy industries. Together with the government’s implicit guarantee of heavy industries, this strategic plan led to China’s investment boom on the one hand and unsustainable growth on the other hand (Chang et al. 2015). Non-state banks, eager to make profits to compensate the regulatory costs, understood such an implicit guarantee and were thus willing to advance credits to the risky industry, most of which belong to heavy industries.
The unregulated entrusted lending activity provided a perfect channel for these banks to circumvent the two regulations because banks can purchase the beneficial rights of entrusted loans (‘entrusted rights’ for short). Analogous to mortgage-backed securities in the US, entrusted rights were issued against these loans to borrowing firms, which gave banks a right to become the ultimate lenders of risky loans. In turn, non-state banks placed entrusted rights in the category of account-receivable investment (ARI). Although ARI is on the asset side of banks’ balance sheet, it is not counted as part of loans (Yap 2015) and thus not subject to the two regulations.
By actively participating in funnelling risky entrusted loans, therefore, non-state banks killed two birds with one stone. That is, they circumvent the safe-loan law and the 75% loan-to-deposit ratio ceiling with an increase of risky entrusted rights. Because entrusted rights were not counted as part of bank loans, non-state banks effectively exploited regulatory arbitrage by trading off the regulation risk of bank loans with the default risk of shadow loans, a unique Chinese institutional characteristic (Figure 3).
Figure 3. An illustration of the Chinese institutions for entrusted loans: How non-state banks funnelled entrusted loans and the associated risks
Notes: ‘Entrusted rights’ refers to investment in purchases of beneficiary rights of entrusted loans, which do not show up in the category of loans on banks’ balance sheet. ‘Safe-loan regulation’ refers to a series of 2010-2013 laws that strictly banned commercial banks from expanding bank loans to the risky industry. The dashed line indicates that the current capital requirement regulation is far from binding.
Our empirical work supports the preceding analysis. According to our micro data, more than 60% of the total volume of entrusted loans was channelled to the risky industry between 2007 and 2013; out of this volume, 77% was facilitated by banks. In particular, the amount of risky entrusted lending funnelled by non-state banks increased by 7.6% in response to a one percentage point drop in M2 growth. More important is the strong correlation between risky entrusted lending facilitated by non-state banks and account-receivable investment excluding central bank bills (ARIX) during the period 2010-2013, which is over 0.5. By contrast, the correlation for state-owned banks is statistically insignificant. Consistent with these correlations, ARIX increased at an alarming speed for non-state banks during the period of simultaneous monetary tightening and rising entrusted lending, while ARIX remained essentially flat for state-owned banks (Figure 4).
Figure 4. ARIX (in trillion RMB) in banks across years
Notes: State-owned banks refer to the big four commercial banks plus the Bank of Communications. Non-state banks include 12 national joint-stock banks and other local commercial banks. “ARIX” is account-receivable investment excluding investment in central bank bills and central government bonds. Shanghai Pudong Development Bank, China Merchants Bank, and Industrial Bank Co. are examples of non-state large banks.
Sources: WIND and the micro data constructed by Chen, Ren, and Zha (2016).
As a result of monetary tightening in 2010-2013, the bulk of shadow lending was channelled by non-state banks into the risky industries; this off-balance-sheet risk was brought into banks’ balance sheet through regulatory arbitrage. The seeds of banks’ risk-taking behaviour were sown in the government’s long-standing preferential treatment of heavy industries as a way to boost investment and thus promote economic growth as a whole. Such financial distortions, along with the mounting corporate and local-government debts in China, will eventually hamper the progress of transforming the economy from investment-led growth to a balanced growth.
The problem has already alarmed Chinese policymakers. Since 2014, the Chinese government has taken concrete steps to enact and implement a host of new regulations in an effort to close the banking regulatory loopholes as analysed in this article. Several new regulations specifically prohibit banks from taking risks in entrusted lending, either on or off balance sheet, to ban banks from paying higher prices than what regulations allowed to meet deposit shortfalls, and finally to remove the decades-long loan-to-deposit ratio regulation all together.
In the context of these new and vigorous regulations, understanding the causes of rising shadow banking and the consequences on the banking system and the real economy will undoubtedly help design a robust macroprudential policy framework in the world’s second largest economy.
Authors' note: The views expressed herein are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Atlanta or the Federal Reserve System.
Allen, F, Y Qian, G Tu, and F Yu (2015), “Entrusted Loans, A Close Look at China’s Shadow Banking System,” Manuscript, University of Pennsylvania.
Chang, C, K Chen, D F Waggoner, and T Zha (2015), “Trends and Cycles in China’s Macroeconomy,” NBER Macroeconomics Annual, 30.
Chen, K, J Ren, and T Zha (2016), “What We Learn From China’s Rising Shadow Banking: Exploring the Nexus of Monetary Tightening and Banks’ Role in Entrusted Lending,” NBER Working Paper 21890.
He, Q, L Lu, and S Ongena (2015), “Who Gains from Credit Granted Between Firms? Evidence from Inter-corporate Loan Announcements Made in China,” Bank of Finland Discussion Paper 1.
Qian, X, and X Li (2013), “Operating Mechanism and Guarding Financial Risks of Entrusted Loans: Stemming from the Public Data of Listed Companies in China from 2004-2013,” Enterprise Development (in Chinese), 10, 125–134.
Yap, Chuin-Wei (2015), “Chinese Banks Look to Shadow Banking for Growth,” The Wall Street Journal, October 30.