There is much noise being made about “China’s shadow banking sector”. As though it’s this unique Chinese invention that’s oh-so-troubling-because-it’s-not-democracy, or something. Some quotes from Time Magazine:

“An expansion of risky and complicated financial practices in the world’s second-largest economy has the potential to explode into a major economic crisis.”

“J.P. Morgan figured in a report last year that shadow banking in China nearly doubled between 2010 and 2012 to nearly $6 trillion, or about 70% of the nation’s GDP. The pace in recent months remains brisk. At the end of 2013, the assets under management at China’s trust firms, one of the primary drivers of shadow banking, increased by 46% from a year earlier. Some of this money is going into risky real-estate developments and other projects that the regular banks have rejected. Even more, the transactions have been poorly-regulated – in fact, many of the deals are designed to circumvent regulation on the banks.”

“Risky real-estate developments” and deals “designed to circumvent regulation on the banks”….

Well, just to be clear, almost every financial system, in any country, is split into two types:

• the Regulated (commercial and retail banks, pension funds, stock exchanges, etc); and
• the Unregulated (investment banks*, hedge funds, private transactions, etc).
  *so investment banks are not entirely unregulated. But this is almost irrelevant – because plenty of investment bank activity will take place in products and instruments that are unregulated, until such time as the government catches up and passes some legislation to regulate it (the classic example: derivatives in the United States).

When people talk about “China’s shadow banking”, it needs to be read in the same context as “US shadow banking” – because that’s also huge, and ironically includes some of J.P. Morgan’s activities. Here are some facts (from this study by the French Treasury):

• In the third quarter of 2008, the US shadow banking sector (SBS) held assets worth $21 trillion (over three times as much as China); and
• That works out to about 145% of GDP (more than double that of China).
• Since then, the industry has contracted by around a quarter – although that depends on how you measure the industry. The FSB, for example, still thought that shadow banking in the United States held assets worth $24 trillion in 2010.
• Also, more importantly, even the Federal Reserve is significantly exposed to the assets that form part of the SBS – seeing as its quantitative easing program involved it committing large amounts of monthly money to Mortgage-Backed Securities, etc.

Here’s a picture of the US position:

What Shadow Banking Actually Is

Shadow banking is just the collective term for anything that looks like banking but doesn’t fall under banking regulation. Here’s a quite long-winded technical definition from Ben Bernanke:

“Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions – but do so outside, or in ways only loosely linked to, the traditional system of regulated depositary institutions. Examples of important components of the shadow banking institution include securitization vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks and mortgage companies.”

So basically, any financial institution that plays around with credit without holding a banking licence is a shadow bank.

Why It Can Be A Problem

Unlike regulated banks, shadow banks don’t have the ability to draw on Central Bank/Reserve Bank money in a crisis.

And unfortunately, as we all have learned, when big shadow banks fail, they take the world with them. Like Lehman Brothers did in 2007/2008, where the Fed desperately wanted to extend them a credit line but was legally unable to. Instead, the Fed was left attempting to persuade Barclays to take Lehman over (it didn’t), and begging Congress to change the law preventing the Fed from helping (which eventually resulted in the Troubled Asset Relief Program, or TARP as we know it today).

And that, right there, is the cause for concern. The Chinese shadow banking sector is taking on risk, and no one is sure if the Chinese government would implement a TARP-type policy in a crisis. If it doesn’t, one bad default could cause the sector to unravel. And imagine a world where all the troubled US institutions had failed.

On the other hand, where would the Chinese economy be without shadow banking?

Answer: not in the place they’re in.

Conclusion: who knows if shadow banking is good or bad? But I suspect that we’re better off with it than without it.