Jason Bedford is in the Asian Financial Institutions Research team at UBS. Prior to that he spent nearly nine years in Beijing primarily as an auditor and consultant for the mainland financial services sector. He had a core focus on the banking sector as well as non-bank lenders (aka shadow banks) which included the trust sector, leasing, micro-finance and credit guarantee. He has been called on to speak as a subject matter expert on these topics by the China Banking Regulatory Commission, the China Trustee Association and numerous banks. He is a qualified CPA and can speak and read Mandarin at a nearly fluent level.
Jason previously spoke at a Young China Watchers Hong Kong event in August of 2013.
Young China Watchers (YCW): Before we get into it, when people use the term ‘Shadow banking’ what are they referring to? What’s its composition?
Jason Bedford (JB): It really depends on who you ask. I don’t think most people understand what the term shadow banking actually means and indeed it feels like everyone has their own definition. The official definition given by the Financial Stability Board (FSB), the organization that really popularized the term is any type of credit not subjected to prudential banking regulation. This has a tremendous capture rate.
Even the head of non-bank financial institutions (aka shadow banking) at the China Banking Regulatory Commission (CBRC) made a comment that betrayed a lack of understanding of what constitutes shadow banking. He rightfully pointed out that the institutions he regulates are all highly regulated and transparent (a fact that is indeed often lost in the media) and that this should be considered “sunshine banking”, not shadow banking. Ironically though (given the natural connotation of the word “shadow”) it is actually not a necessity to have a lack of transparency or be unregulated to be defined as a shadow banking institution or activity. The FSB is in the process of rationalizing the term and so the efficiency of the term should hopefully be improved.
YCW: Not to put words in your mouth, but you are known for your view that much of the risk surrounding shadow finance is over-hyped. What is the thing that worries you the most? And, what would have to happen for you to shift to a more bearish viewpoint?
JB: You are not putting words in my mouth at all; the perception of risk surrounding shadow banking is over-hyped. The first thing to realize is that shadow banking is not a “thing”. The key flaw with the term though is that it captures what are a very disparate and uncorrelated range of institutions and activities. In effect the term groups together pawnshops with off-balance bank securitization and illegal moneylenders with the auto finance subsidiaries of major auto manufacturers and appears to apply a commonality between these things. There is no shadow banking sector or the “Global Conference of Shadow Bankers”.
Now this is not to say that shadow banking poses no risks, but those risks can only be understood at an entity level. A better lens through which to understand the risk of shadow banking is to break it down into its commensurate parts: bank-linked shadow banking activities (I.e. securitization, entrusted lending and credit exposures that appear on-balance sheet as investments not loans), non-bank financial institutions (I.e. trust companies, credit guarantee companies, the credit portion of securities companies’ assets under management (AUM), the credit portion of fund management companies’ AUM, finance companies, auto finance companies, micro-credit companies, leasing companies, consumer finance companies, P2P lenders, etc.) and predatory lenders (the receivables portfolios of the big four Asset Management Companies, pawnshops and underground banks—a portion of trust AUM might fall here as well). The term predatory lender is not necessarily negative; it denotes institutions that charge excessively high interest rates and/or for which default is not an undesirable outcome to loan resolution (due to excessive collateralization of the loan). And the China market, like any other market, has enterprises and people with sudden short-term financial needs that these firms meet.
In terms of what concerns me, I see entrusted lending most along with banks shifting loans to other parts of their balance sheet as key risks. Entrusted lending is a type of corporate to corporate lending that is facilitated by a bank or finance company as an intermediary. In practice though the bank or finance company only generates a few basis points of fee income in exchange for the facilitation; it plays no role in the loan assessment or ongoing risk management of the loan. I think that making informed lending decisions is a skill and that a forestry company in southwest China making 24% interest rate entrusted loans to third party companies is a risky departure from their core business.
The other concern for me is the shifting of loan assets out of bank loan books and into trust beneficiary rights and directional asset management plans where they appear in interbank repo positions and investment books in order to understate capital ratios and loan to deposit ratios is also very risky—although this appears to be a risk that the CBRC has been actively addressing and cracking down on. Continued growth of either of these two items would harden my views on increasing risk as a result of shadow banking.
YCW: How does China’s shadow banking compare to other large economies?
JB: China’s shadow banking sector is significantly smaller than shadow banking sectors in other economies. But what is more important to focus on are the underlying forces behind it. Shadow banking in the US was driven by deregulation of the banking sector and was really an outgrowth of banking-sector linked activities—credit default swap, securitization, mortgage-backed securities, etc. However, in China the process has been almost in reverse.
Shadow banking was driven by excessive regulation of the banking sector and as a response to financial repression caused by the regulated deposit regime in China. Bank-linked shadow banking activities for example are aimed more at getting around strictly enforced capital adequacy requirements and loan-to-deposit ratio requirements. Moreover, regulated non-performing loan ratios have made banks in China extremely risk adverse—to the extent that bank lending preferences created a very inefficient allocation of capital where lending was concentrated to corporates in the state-owned sector at the expense of SMEs and privately owned corporates. Non-bank lenders thus developed in response to the urgent need for financing.
YCW: In an economy like China’s, where large parts of the financial sector remain underdeveloped, shadow banking is providing credit for firms that might otherwise not get it. How do the positive aspects of shadow banking compare to the negative?
JB: There is an argument to be made that every dollar of shadow credit possibly has a more economically efficient impact than every dollar of bank financing as it goes to a more vibrant and rapidly growing part of the economy—versus stagnant state giants. Again though, the important distinction to make is that portions of shadow banking sector are naturally benign in nature, particularly non-bank lenders such as a micro credit companies, leasing companies, consumer finance companies, etc. Leasing companies only sound risky when you call them shadow banks instead. Similarly, it is not incorrect to state the world’s most preeminent shadow banker is Mohammed Yunus, winner of the Nobel Peace Prize and inventor of micro-credit.
Risk cannot be discussed or understood through the lens of shadow banking, it can only be understood when you break it down into its commensurate parts. Even predatory lenders play a valuable role; while they are criticized for providing loans at usurious rates, efficient markets need an outlet for very short notice, short term credit facilities.
YCW: Last year, a lot of people were talking about shadow banking, loose credit, and bad loans in China. Some mentioned the coming of China’s ‘Lehman Moment’. But that seems to have dropped from the scene. Were people just wrong? Or did China do something to avoid that?
JB: People were just wrong. And to clarify, people were actually describing a series of failed trust products as China’s Bear Stearns moment (the implication being that the Lehman moment was to follow soon). However, this suggestion betrays a complete lack of understanding of how the trust sector functions and the role it plays in China’s capital markets. From a Western standpoint, trust companies are naturally understood and categorized as China’s high-risk lenders. And on the front of it that logically makes a lot of sense; after all you have lending institutions making high interest rate loans to borrowers that can’t access to bank financing. However, you have to realize that China is still developing and it has a very inefficient banking sector in terms of the allocation of capital it creates (albeit this is changing very rapidly). Consequently many good companies lack access to financing.
More importantly though is that the People’s Bank of China and CBRC use sector bans or loan quotas to limit lending to certain industries deemed high risk or at risk of over-heating. Every time this happens, it creates an opportunity for trust companies to target the top borrowers in that sector. This is consequently why exposures to real estate and infrastructure built up very rapidly and suddenly at various times. In a sense they should be thought of as an arbitraging institution that fills gaps left open by the banking sector. After all, these are inherently counterintuitive institutions: they issue loans at higher rates than the banks, require far more collateral (and yet the same type of collateral) as banks and the consequences of default are more profound for borrowers as trust loans are typically structured under repurchase agreements whereby the borrower transfers ownership of an asset in exchange for financing and at the end of two years that asset is returning if the loan is paid back– if not the trust company will simply formalize ownership and seize the asset. Under that business model, they don’t really have a role in an efficient capital markets environment. And this is why the greatest risk facing trust companies is not credit/reputational risk but strategic risk.
Thus, while a few trust companies are undergoing significant stress in terms of asset quality, the bigger concern is staying relevant. All this current talk of peak redemption periods of trust products (the idea that at a given time of the year a large portion of trust loans will come do that can’t be rolled over) is equally misguided. The bigger stress facing trust companies right now is not whether their borrowers can afford to repay at the end of the two-year product but rather will they stick with the trust company on the same loan terms and continue the financing.
YCW: Where is shadow banking heading now in China? Where should it be heading?
JB: The market still has a need for shadow banking and I think over time it continue to increase and change in response to market needs. There are already interesting trends taking place in the consumer credit space that will lead to very interesting developments for growth.
– Interview by Oliver Chase