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While profits and asset growth at China’s big four state-owned commercial banks have flatlined, midsized Chinese lenders continue to grow aggressively through shadow banking.

The rise of Chinese shadow banking, beginning around 2010, focused on banks shifting loans off-balance sheet through partnerships with non-bank financial institutions such as trust companies and securities brokerages. During the past two years, however, midsized banks have rapidly expanded on-balance sheet assets.

Analysts say most of these assets are in effect loans but are structured to appear as holdings of investment products issued by a third party. Such financial alchemy allows banks to evade regulations designed to limit risk.

Banks are required to set aside fewer provisions against “investment” assets than traditional loans. Such assets also carry lower risk weightings under China’s capital adequacy rules, meaning reported capital ratios may not reflect lenders’ true risk position.

Because the investments are not classified as loans, defaults are not reflected in these banks’ non-performing loan ratio. Many analysts believe China’s official NPL ratio of 1.67 per cent is all but irrelevant in assessing banks’ overall asset quality.

Fitch, the rating agency, believes this practice, also known as channel lending, is used to provide credit to the likes of “cash-strapped property developers and local governments” that cannot obtain formal loans.
“Channel loans have limited disclosure and transparency, which exposes the banks to additional credit risks beyond their loan books,” said Katie Chen of Fitch.

“Complicated transaction structures, which involve various intermediaries providing channel services, reduce clarity about where the risks ultimately reside.

Now that overcapacity sectors such as steel and cement are facing restrictions on formal borrowing, channel lending could become even more important to zombie companies.

Banks can channel funds to a corporate borrower by buying so-called trust beneficiary right or private placement asset management plans from an intermediary such as a trust company, brokerage or special purpose vehicle. The intermediary then extends loans to companies. Banks classify the assets they hold in these third parties as “investment receivables” or “debt receivables”, not loans.

Shadow lending in debt receivables increased 63 per cent to Rmb14tn ($2.16tn) last year, according to an analysis of 103 Chinese banks by Wigram Capital Advisors, equivalent to 16.5 per cent of the formal loan book.

Moody’s, the rating agency, said in its Quarterly China Shadow Banking Monitor on Wednesday: “The developments [in the shadow banking sector] point to rising interconnectedness, among banks and also between banks and the shadow banking system. Mid-sized banks are particularly exposed.”
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