Regulation leads to innovation

The Chinese government is in the process of deregulating interest rates. It took the first step in July 2013 when the People’s Bank of China (PBOC) freed the banks to set the rate charged to borrowers, other than some mortgage-related restrictions. It is expected soon to stop controlling the rate paid by banks to depositors. That would allow market forces rather than government targets to set the key short term price of capital in the Chinese economy,

One reason for doing this is that the authorities are keen to halt and reverse the growth of the Chinese shadow banking system. Shadow banking refers to institutions and flows of funds which economically are the same as banks but are not regulated. The term originated in the US but is equally applicable to China. The essence of shadow banking is a channel for funds from households to companies which doesn’t go through the banking system, or at least is off balance sheet. This is true of both the US and China but the actual institutions differ.

What China and the US have in common is that the shadow banking system arose as a result of regulation. It is a common theme that innovation (whether good or bad) is driven by the search to get round constraints. This is particularly true in finance.

The US route

The main form of shadow banking in the US consists of money market funds, which receive money from ordinary households, and invest it in short term instruments such as commercial paper, which in turn is issued by companies and, up till the crisis, by special companies set up by banks. These special companies were created to shift assets, mainly mortgage loans, off the balance sheets of the commercial banks, to reduce their capital costs. Banks are required to fund assets in part with capital – equity – but if they hold them off balance sheet they can keep most of the economic benefit at a lower cost of funding.

Money market funds exist mainly because Regulation Q put a ceiling on the interest rates that banks were allowed to pay to depositors. MMFs, not being bank deposits (though households treated them as if they were), were exempt from this so they attracted very large inflows when inflation rose in the 1970s and the banks’ real (inflation-adjusted) deposit rates were negative. Even after US interest rate regulation was completely abolished in the 1980s, MMFs lived on because they offered a slight interest rate advantage over deposits owing to their scale – they could invest in the wholesale money market.

Money market funds exist in Europe but on a smaller scale, mainly tapping institutional funds rather than retail.

So both MMFs, as the source of funds, and the banks’ off-balance sheet vehicles, as the destination, arose from US regulation. Nobody, including regulators, seemed to notice the scale of this alternative funding mechanism, or the fact that it was unstable, until the fall in house prices made many of the mortgages lose value. The abrupt withdrawal of MMFs (commercial paper is typically 3 months in maturity, so every three months these special companies had to refinance their liabilities) made the off balance sheet companies unviable. Although not legally required to do so, the commercial banks felt obliged to put the assets back on their balance sheet, rather than leave customers to incur losses, causing the banks to absorb multi-billion dollar losses instead, especially at Citigroup.

The off balance sheet vehicles, known as SIVs and conduits, have, for the moment, disappeared. But MMFs continue and are still largely unregulated, having fought off attempts to require them to hold some sort of capital buffer, like banks.

Shadow banking with Chinese characteristics

China’s financial system remains dominated by the commercial banks. The equity market is small and widely distrusted. And there is no corporate bond market to speak of yet. So most funding goes through the banks. Interest rates to depositors and lenders have been controlled by the PBOC until very recently. This, together with quantitative “guidance” to banks, ensured that lending was directed towards state owned enterprises and local governments as low rates, at the expense of households who put their money into the banks. The system delivered fast GDP growth through high investment, but stored up problems of mis-priced and mis-allocated capital. It also encouraged depositors to seek higher rates, just as in the US.

The Chinese shadow banking system has several components but the common thread is households chasing higher yields. Banks offer products which pay higher interest and then invest in corporate loans, often real-estate related. These “wealth management products” are organised by banks as agents but they’re not on the banks’ balance sheets so they escape regulation.

Other products sold to households are offered by non-bank financial institutions, called trust companies. These provide loans to companies that have been typically shunned by the banks and the rates paid allow a higher return to the household investors.

There are various other channels and mechanisms for lending, ranging from barely legal to absolutely illegal. The demand for funds from companies denied normal bank credit is very high. The supply of funds from households seeking better interest rates is equally high. Where demand and supply exist a market will typically arise, even when there is a threat of death if you get caught.

Two problems arise with Chinese shadow banking. First, households are taking on far more risk to achieve the higher return. They may not realise this, or they may assume that the banks will stand behind the products they’ve sold, in the event that the loans are not repaid. This represents a large and poorly defined element of risk in the system.

Second, the growth of shadow banking has undermined the PBOC’s attempt to reduce total credit in the Chinese economy. Formal bank credit growth has been successfully constrained but shadow banking lending has grown substantially in recent years. “Total social financing”, which is an attempt to capture all credit, grew 60% relative to GDP in the four years to 2013, according to the 2013 IMF Article IV report on China.

The future

Deregulating Chinese interest rates should lead to higher deposit rates for households, cutting their demand for shadow banking products. But the US history of MMFs suggests that these institutions will live on, unless outright prohibited or regulated out of existence. Once a group of profitable businesses has established a market, they will not give up without a fight.

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