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22 February 2013 Economics Research

http://www.credit-suisse.com/researchandanalytics

China: Shadow banking – Road to heightened risks
Research Analysts Dong Tao +852 2101 7469 dong.tao@credit-suisse.com Weishen Deng +852 2284 5751 weishen.deng@credit-suisse.com

 Shadow banking activity in China has surged in recent years. We estimate its total size at RMB 22.8tn, 44% of GDP. We estimate it counts for 25% of total outstanding credit and half of new credit issued last year. In this report, we attempt to assess the medium-term risks related to shadow banking.  The fund raising and lending activities of shadow banks are fraught with irregularities. Many products currently offered look like the CDOs offered in the US before the financial crisis, albeit without established regulation and surveillance. The trust sector has surpassed insurance as the second largest financial sector now, and the brokers’ asset management business is growing at a pace of RMB 10bn per day. Outstanding bank WMPs hit RMB 7.6tn, while the corporate bond market is blossoming – and local governments are big on the receiving side of corporate bonds.  A key catalyst for turning a boom into a bust is the rise of inflation, which could force the PBoC to raise interest rates were it to occur. That should dry up the fund influx into bond market and wealth management products. We believe any consequential defaults of shadow banks might force banks into bailout, triggering a credit contraction.  We expect a potential credit contraction to be problematic for the property market, local government debt, and shadow banking. Bank NPLs may rise sharply. It is hard to pin down the timing of such an event, but we tentatively look at the period between 2015 and 2017.  The central government debt-to-GDP ratio stands at 15%. Adding local debt and other tangible liabilities, the ratio is 72%. We believe that Beijing has the fiscal strength, political incentive, and policy know-how to bail out the banking system, but pre-emptive resolutions are unlikely.

Exhibit 1: The great credit surge
170 150 130 110 90
Note: * Total outstanding credit is based on PBoC's total social financing record

Credit*-to-GDP (%) Loan-to-GDP(%) Alternative Financing

70

Source: PBoC, CEIC, Credit Suisse

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22 February 2013

Shadow Banking – Road to heightened risks
The great credit surge
Throughout the past decade, China has been on a path of monetary expansion and leveraging-up. The People’s Bank of China has printed more money, via an expansion of its balance sheet, than the Fed, ECB, or BoJ. As a result, property values and SOE assets have increased. The leveraging-up process generated a rapid expansion in industrial capacity between 2004 and 2008, a property boom between 2005 and 2011, and a local government debt surge between 2009 and now. In fact, China saw the biggest credit expansion relative to GDP over the past decade than any other country in modern history. China’s M2 GDP ratio now stands at 187%, its gross capital formation GDP ratio at 48%, and its credit (based on total social financing) GDP ratio at 176%. When banks began to be reluctant to take on risk and slowed their lending, shadow banking activities took off.

Exhibit 2: China’s exceptional growth is not only in its GDP, but also in its money stock
800 700 600 500 400 300 200 100 0 PBoC Fed ECB BoJ* M2 growth between between 2000 and 2012 (%)

Exhibit 3: … or putting these two variables together
China (M2/GDP %) US(M2/GDP %) The EuroZone(M2/GDP %) Japan(M2/GDP %)

190 150 110 70 30

1995

1998

2001

2004

2007

2010

Source: Thomson Reuters DataStream, CEIC, Credit Suisse

Source: Thomson Reuters DataStream, CEIC, Credit Suisse

Today, we estimate that shadow banking activity totalled RMB 22.8tn, or 44% of GDP, in 2012. We estimate that it accounted for 25% of total outstanding credit and a half of total credit issuance last year, yet it operates without established regulation and surveillance. The question for us is no longer whether but when and how China’s credit bubble will end. The next question, of course, is how this may affect the economy.

Exhibit 4: Size of shadow banking activities
RMB tn Trust Funds Bank Wealth Management Products Broker Asset Management Underground lending LGFV corporate bonds outstanding Total % of GDP As of 2012 7.5 7.6 1.9 4.0 1.8 22.8 43.9

Source: CBRC, China Trustee Association, Securities Association of China, WIND, Credit Suisse estimates

China: Shadow banking – Road to heightened risks

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We believe the good news for now is that it is not yet “fashionable” for Chinese WMPs to contain a leverage element. prompting banks to remove developers and local government from their lending lists. even the designer did not know what the underlying investment was. We believe the bad news is that the Chinese banks are distributing these WMPs directly to retail investors who may have little understanding of this type of product and are seeking the rent from the information asymmetry. Credit Suisse 3 . and are vulnerable to tail risks. The trust sector blossomed when the central bank used loan quotas to manage the credit environment. CEIC. Among the eight trust funds. Some of the WMPs the Chinese banks are offering today looks similar to the securitized products that investment banks in the US had offered before the crisis. According to the designer. and in terms of the other two trust funds. Before 2005. Buyers usually are not aware of the underlying risks. These products have little transparency and a complicated structure. causing deposits to be withdrawn 2002 2004 2006 2008 2010 2012 Note: * Total outstanding credit is based on PBoC's total social financing record Source: NBS. seem tied to higherrisk underlying investments. which borrowed money from foreign banks and went bankrupt in 1999) and stated-own trust companies in the earlier age of China’s economic reform prior to 2000. In 2007 trust funds totalled RMB 950bn in size and now have reached RMB 7. Bank sales people may be misinforming customers with an implicit guarantee.22 February 2013 Exhibit 5: With investment being the key driver of growth Exhibit 6: … the Chinese credit boom became apparent 190 Credit*-to-GDP (%) Loan-to-GDP(%) Alternative Financing  55 50 45 40 35 30 25 20 15 Gross fixed capital formation (% of GDP) Estimate 160 130 100 70 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Source: NBS. China virtually had no trust fund products. three are lending to the property markets. Meanwhile.5% guaranteed return product was structured from eight trust funds and four corporate bonds. he tracked down the person who designed this product. despite the wave of international trust companies (the most well know was Guangdong International Trust Investment Company. It seems that high risk securities have been packaged into securitized products and are being sold as “low risk” financial instruments (sometimes with guaranteed returns). Those that lost access to bank loans turned to trust funds for funding. An acquaintance in Shenzhen was approached by a bank sales person selling a wealth management product (WMP) that offers 7.5% return turned up little information from both the sales person and the product team that designed this product. CEIC. Credit Suisse China: Shadow banking – Road to heightened risks 1990 1992 1994 1996 1998 2000 Anecdotal evidence Allow us to start with a piece of anecdotal evidence that we believe is illustrative of the practice of the shadow banking. this 7. three are lending to local governments’ infrastructure projects. the central bank kept the deposit interest rate excessively low when inflation was heated. Eventually.5tn – increasing almost eight times their size in five years. are lacking a regulatory framework. His requests to know what was behind the WMP’s 7.5% annualized guaranteed return.

With the property sector seeing improved transaction volume and pricing. the government obliged banks to carry the costs (it did help to restructure the lending to longer durations and with more collateral). typically 2-3 years in duration. Most trust funds are used to fund property projects after banks were instructed by the central bank to discontinue lending to developers in mid-2010. to us. to retain depositors. when the debt chain at Wenzhou broke down. Banks use WMPs. Credit Suisse Exhibit 8: … after the surge seen in recent quarters 8. trust fund products have a maturity date.000 7. was a purely fiscal action while banks have been used as a temporary funding source.470 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2007* 2008* 2009* End of 2012 Source: China Trustee Association.000 6. as it did in October 2011. The 2009 action. And trust funds usually have a thin capital base. However. we suspect it would be the same this time. regulations and surveillance have not been properly set up. Judging from the health of local governments’ balance sheets and the anecdotal evidence we have seen. Should a fund run into repayment trouble. Most of this batch comprises lending to local government projects. 2 financial sub-sector in China 8000 7000 6000 5000 4000 3000 2000 1000 0 Trust Sector Insurance Trust Sector Insurance AUM Sector Total AUM Sector Total Asset Asset End of 2010 Source: China Trustee Association. Credit Suisse China: Shadow banking – Road to heightened risks 4 .000 4. When that lending turned sour. perhaps causing a false sense of guaranteed return) would have to pay the bill. in our view. we expect most trust funds to be able to make the repayments. Yet. assuming that Beijing would not let retail investors take a deep haircut to avoid risking social unrest. but may not be providing proper disclosure of the risks. The delayed payment of RMB1bn by CITIC Industrial Trust is an example. Exhibit 7: Trust sector has overtaken the insurance sector as the No. Rmb bn 7. The roadmap to systemic risk? The trust sector has just surpassed the insurance sector as the second largest financial sub-sector in China. The government’s behavior after the 2009 lending to local government investment vehicles provides a good benchmark. figures for 2010 onward are released by China Trustee Association. Unlike bank lending that be rolled over in the event of NPLs.000 5. we believe there are likely to be some defaults or restructuring.000 3. 2008 and 2009 figures are numbers reported by local press. If that were the case that time. The first wave of trust funds will reach maturity around the middle of this year. but we expect that to be an isolate case that Beijing could fund to stem the damage.22 February 2013 from banks. The second wave of trust fund repayments is due to arrive in late 2014 to 2015.000 Rmb bn * 2007.000 2. Irregularities in both fund raising and lending seem frequent and systematic. in our view. or the banks (which helped the trusts raise funds.000 1. which offer higher yields. the obvious question is: Who would pay the bill? Either the government would have to pay the bill. we would not be surprised to see a large-scale default.

some government bodies have put out some restrictions on certain types of shadow banking operations. Typically. and the banking sector has to a significant degree failed in its role of financial intermediary. It is our view that the possibility of a series of defaults among the trust funds. the funding pool concept is spreading quickly in the industry. Indeed.22 February 2013 Should infrastructure-investment-focused trust funds run into default and banks be forced into bail out. More than just trust funds China’s potential shadow banking problems go beyond the trust funds. have attributed to the surge in shadow banking. Investment management run by brokers is another booming area. The returns on existing trust funds. and WMP would all look less appealing to depositors. Shadow banking activities have increased because China needs growth. That could lead to a chain reaction. We expect RMB 500bn-RMB 700bn of insurance funds to filter into shadow banking directly or indirectly. Three major factors. yet without disclosing what securities they will buy later. Private investment has disappeared in China. underlying risks are not properly disclosed. the money put into the funding pool will mature in 3-6 months. Without the re-engagement of private investment. leading to a credit contraction. according to the CBRC. banks’ equity bases would be damaged. First. and we see the upside risk for inflation to reach above 5% by end of 2014. The current size of broker-related asset management is about RMB 2tn. perhaps without proper assessment of their long-term risks. It may ban one type of financial instrument. leading to a sharp slowdown in bank lending. insurance companies are allowed to buy riskier assets like trust products. possibly also bursting the local government debt bubble and the shadow banking bubble. would trigger a sharp correction in the property sector. Why doesn’t Beijing stop shadow banking activities? We believe the entire push behind shadow banking is deeply rooted in the government’s desire for growth. Third. The banks’ WMP products together are estimated to be about RMB 7. regulation is absent. The pace of such a credit contraction might be more severe than the market’s current expectation. we believe the government will have no choice but to rely on infrastructure projects. After a round of deregulation. the risk mismatch is obvious. On top of being the pro-active middleman connecting retail money and trust funds. Second. Brokerage houses act as banks’ vehicles to securitize debt from local governments and property developers. Banks are evolving into asset management companies.6tn. Banks are selling customers “funding pool” WMPs. excessively low interest rates prompted the exit of deposits. a lendingquota-based macro management system has forced banks to move lending activities from on balance sheet to off balance sheet. but it is growing at a pace of RMB 10bn per day. in our view. China: Shadow banking – Road to heightened risks 5 . putting these instruments onto their books as assets under their management. usually with a verbal commitment on investment return. but the core issue has not been addressed. as manufacturing production becomes unprofitable due to surging salaries and severe over-capacity. Insurance companies are entering into this field as well. as inflation is projected to surpass 4% yoy by the end of 2013. but the residual of the pool allows banks to buy corporate bonds and other securities with maturities of 3-10 years. but it still has to deliver liquidity to local governments through alternative channels. so banks have to use alternative investment instruments to retain their revenue-generating base. corporate bonds. And funds raised through different WMPs are then pooled together. pressure for profits has made banks go after highermargin products. The duration mis-match is obvious.

from its current 2.0%. as the funding drain and duration mismatch would be likely to be exposed. That might trigger a simultaneous bursting of the bubbles in the property sector.0 4. we project inflation will reach 4%. are appealing. there is a good chance that the CPI could move towards 5%. (3) excessive deleverage on property and collateral value of land. A frequently heard counter-argument to our cautious assessment on shadow banking is that of collateral value. e. Given their deep involvement.0 2. local government debt..0 8. (4) sensitivity to interest rate movements and property prices. We would not expect a greater than 50% fall in land values (it is possible though). regardless of their point of origin. (5) lack of regulation externally and risk management internally. it would weaken banks’ balance sheets.0 0. The market would then be much more concerned about credit risk among shadow banking entities. Should that happen.g.22 February 2013 Road to the great credit contraction? China’s shadow banking sector has certain characteristics: (1) a complicated structure and poor transparency. forcing the central bank to tighten in 2014. (2) many interrelated products. The PBoC’s window of monetary easing is closed. with undisclosed or improperly disclosed risks. and (6) critical dependence on a continued influx of capital and potential exposure to excess risk if liquidity becomes a problem. and shadow banking. Trust fund products and local-government-related corporate bonds point to the underlying collateral – land. Should markets anticipate that. Most shadow banking entities run on a thin equity base. especially the pork cycle. but also in formal banking. has already started moving upward. property and stocks. By the end of 2013. The food cycle. the capital base would likely be wiped out. causing credit to start to contract. Exhibit 9: Headline inflation is on the rise 10. then the fund influx to the bond market and WMPs could dissipate. so if one or two projects default.0 -2.0 -4. banks might well be asked to take on the responsibility of repayment. not only in shadow banking.0 Consumer Price Index (% yoy. 3mma) Source: NBS. but emphasize the importance of liquidity. Credit Suisse A key catalyst that we think could turn the shadow banking sector upside down is the incoming pick-up in inflation and potential for an eventual interest rate hike. in our view.0 6. especially if alternative investment options. Lehman held quality assets but went under when Jul-13 Jan-13 Jul-12 Jan-12 Jul-11 Jan-11 Jul-10 Jan-10 Jul-09 Jan-09 Jul-08 Jan-08 Jul-07 Jan-07 Jul-06 Jan-06 Jul-05 Jan-05 Jul-04 Jan-04 Jul-03 Jan-03 Jul-02 Jan-02 Jul-01 Jan-01 Jul-00 Jan-00 Jul-99 Jan-99 China: Shadow banking – Road to heightened risks 6 . with a 50% discount to NAV. Judging from the rise in rents and salaries.

we see the potential for a crisis somewhere around 2015-2017 that involves deleveraging in local government debt. we believe the rest would be likely to be relatively easy. The latest year for which we can find all the debt figures is 2010 – when the total size of government debt stood at RMB24. In our opinion. then there would be no crisis (hence no reward). Once the funding of a bailout plan is agreed upon. with a deficit to GDP ratio at 1. In our judgment. Ministry of Finance. Ministry of Railways. This may be an unpleasant event with lots of cross-casualties. at the end of 2012. Exhibit 10: Government-related debt projections RMB tn National Government Debt Local Government Debt Policy Financial Bond Outstanding Ministry of Railways Debt Total % GDP 2010 6. Government bailout? Assuming no action to curb the booming shadow banking activities. politicians would face a dilemma.3 2012 Projection 8. Although local governments’ deficit to GDP ratio reached 8.5 8.8 *Projection Assumption 2011 outstanding debt plus 2012 deficit Based on average growth rate of the previous 5 yr period (31. China: Shadow banking – Road to heightened risks 7 .8 10. if they fail. Details are listed in Exhibit 10. Beijing arguably has the best execution ability among all the large economies.5% in 2011. In our view. then they would likely face criticism. the central government’s fiscal condition looks healthy. the ministry of railways and policy banks.0 18.9 24.3 71.3tn. Credit Suisse estimates The tangible liability is harder to estimate. AIG’s assets are sold at a profit today. the property market and shadow banking.7 5. We believe it might take a crisis for the top leaders to agree on a large sum bailout plan.2 1.8% of GDP. if the credit market were to dry up and the property market were to see a correction. we project the total debt reached RMB 37.6 tn.3% of GDP. but it could not survive without the bailout from the US government.5%) Assume Q4 debt increase by the same amount as Q3 Source: National Audit Office.0 2. CEIC. or potential liabilities for pensions and health care.8 37. Beijing does have the fiscal strength to bail out the financial system one more time. but China also has many SOEs where the asset values have substantially risen over the past decade.4%) Based on average growth rate of the previous 5 yr period (21. At the end of the day.6 61. the cost of bailing out during a crisis could be substantially higher than it might appear on paper. If they are successful.1% and debt to GDP ratio at 15. That does not include RMB 80tn of SOE assets controlled by the state. though the initial dip could be much steeper than China has experienced in 2008. Of course. but would probably not be ‘the end of the world’. we would see limited demand for land if the entire country were attempting to sell land.2% as of the end of 2011. Before a crisis strikes. or 71. Based on currently available data.22 February 2013 liquidity dried up. or 61. we would anticipate a V-shaped recovery. Will the government take pre-emptive steps to stem a potential crisis? We hope so. when we include debt owned by local governments. but think it unlikely. QE and stimulus. The prescription for handling a financial crisis is readily available – fiscal bailout.

Not all of the funding funneled through shadow banking is to local governments or the property sector. the trust funds. a detailed breakdown of the direction of lending is impossible. We have used official or semi-official data (e. we estimate the total reached RMB 22. and underground lending. the bank wealth management products. the broker-asset management products. In the second half of this report. local governments’ shadow financing activities through LGFV bonds. published by the state media) regarding the size of each kind of shadow banking.8tn.g.22 February 2013 More about shadow banking Aggregating the sizes of major shadow banking activities. Not all shadow banking activities are exposed to excess risks.. Because of the nature of off-balance sheet operations and the relatively weak regulatory environment. but would not be surprised if the actual size turns out to be bigger. or 44% of GDP in 2012 (Exhibit 4). China: Shadow banking – Road to heightened risks 8 . we look at the different forms of shadow banking activities in further detail.

e. Off-balance sheet activities and corporate bond markets have been furthering their role in providing credit to the economy. we call these four items alternative financing activities. we estimate the total reached RMB 22. we provide a brief overview of these shadow banking activities in China. Trust loans. the gap between loans and total credit widened. published by the state media) regarding the size of each kind of shadow banking activity. Exhibit 11: Players in the shadow banking system Commercial Banks' offbalance sheet banking Shadow Banking System Underground lending market Trust Companies Others.2tn. and banker’s acceptance bills are the off-balance sheet shadow banking items in the PBoC’s total social financing account.g. There is no official definition of shadow banking. growing by 50. The driver behind this was the surge in alternative financing activities. the bank wealth management products. a detailed breakdown of the direction of lending is impossible. and underground lending. Contrary to loans. local governments’ shadow financing activities through LGFV bonds.9% from RMB 3. entrusted loans.8tn. Corporate bond issuance is also included in the total social financing. but aggregating the sizes of major shadow banking activities.. The total social financing grew RMB 15. but total credit growth in China was strong. We used official or semi-official data (e. these items are not subject to the constraints imposed by either the loan-deposit ratio or loan quotas. the trust funds.22 February 2013 China’s Shadow Banking – At a glance The surge in shadow banking activities fueled our concern about credit overheating in China. Overall. Over the course of 2012 in particular.8tn in 2012. and finally recent developments such as broker asset management operations. First we will give some overviews on recent trends. Exhibit 13 shows a sharp increase in the total credit in China from the beginning of 2009. but would not be surprised if the actual size turns out to be bigger. 9 China: Shadow banking – Road to heightened risks .9tn in 2011. new credit raised through alternative financing activities reached RMB 5. In this section. new bank loans came in at the expected RMB 8. As opposed to the conventional bank loan channel.g. the broker-asset management products. starting with the trust fund activities. Because of the nature of off-balance sheet operations and the relatively weak regulatory climate. Then we will go through the key areas of shadow-banking-related operations. or 44% of GDP in 2012.9tn in 2012. 23% higher than the growth seen in 2011. followed by LGFVs’ corporate bond issuance. the bank wealth management products. Exhibit 12 shows the upward trend of alternative financing activities in 2012. while the conventional bank loan channel’s role seemed to have decayed. Financing guarantee companies Brokers LGFVs Source: Credit Suisse Potential new joiner: Insurance companies Recent trends in shadow banking activities Conventional bank loans did not have a particularly exciting year in 2012.

at the narrowest scale. which was 1. As of the end of 2012.6% of the new credit to the economy. local governments are increasing their use of the corporate bond market as their funding source of choice for public spending projects.4tn in 2011. local governments’ shadow financing activities through LGFV bonds. outstanding shadow banking credit from the PBoC’s total social financing (trust loans.8tn. the trust funds.5tn. Corporate bond financing and Banker's acceptance bill . up from RMB 290bn in 2011.000 160 60 1. entrusted loans.5tn and RMB 4tn. and possibly higher risk. on average there were 56 court cases related to underground lending per day in Wenzhou city. Behind the increase was the local government and infrastructure-investment-related bond new issuance hitting RMB 800bn. Aggregating the sizes of major shadow banking activities. Underground lending is one of the shadow banking activities in China. the bank wealth management products.2% of the new credit. The link between the corporate bond market and shadow banking activities has strengthened over this time through the implicit local government guarantee of corporate bonds and the deepening involvement by commercial banks and trust funds. shadow banking credit reached 28% of GDP. That is to say.22 February 2013 To provide further detail.3tn in 2012. Credit Suisse Corporate bond financing also increased significantly. According to the official media (CCTV). Credit Suisse Source: PBoC. Exhibit 12: Alternative financing activities show upward trend over the course of 2012 Monthly society-wide financing (Rmb bn) Alternative financing* as % of incremental society-wide financing New bank loans as % of incremental society-wide financing 90 Exhibit 13: … becoming the key driver of the credit boom 190 Credit*-to-GDP (%) Loan-to-GDP(%) Alternative Financing 2.000 500 0 130 100 Jun-12 Jun-11 Jun-10 Sep-12 Dec-12 Sep-11 Dec-11 Sep-10 Dec-10 Dec-09 Mar-12 Mar-11 Mar-10 70 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 * Alternative financing including: Trust loan. the city known for its manufacturing exports. from RMB 1. that is 44% of GDP in 2012. housing market speculation and underground lending. banker acceptance bills) amounted to RMB 14. with the amount of increase reaching RMB 2. Underground lending became a source of major concern in 2011. this amount surged to RMB 1. and underground lending. We believe it is at the higher end of this range. Entrusted loan. new trust loans totalled only RMB 203bn in 2011.500 2. On top of this are the wider “grey areas” such as underground lending that are harder to monitor and regulate. the broker-asset management products. Associated with this jump is that the trust sector has overtaken the insurance sector to be the second largest financial sector in China. China: Shadow banking – Road to heightened risks 10 . as the government started to tighten credit conditions in an effort to cool down the housing market and the global headwinds hitting the Chinese economy. forming 8.500 30 1. we estimate the total reached RMB 22. Note: * Total outstanding credit is based on PBoC's total social financing record Source: China Trustee Association. The market generally estimates the size of underground lending to be between RMB 3. in the first seven months in 2012. Clearly.3tn in 2012.

in 2012 Q4.470 8000 7000 6000 5000 4000 3000 2000 1000 0 Rmb bn Trust Sector Insurance Trust Sector Insurance AUM Sector Total AUM Sector Total Asset Asset End of 2010 Source: China Trustee Association. their proportion declined to 27%. In 2010 Q3. Trust companies can play both proactive and passive roles in the popular trust fund operations. raise funds from investors. “Bank-Trust” products contributed 64% of the AUM of the trust sector. loan type “Bank-Trust” wealth management products cannot exceed 30% of the total assets under management of a “Bank-Trust” wealth management operation. Usually in this type of operation.000 2. Credit Suisse China: Shadow banking – Road to heightened risks 2007* 2008* 2009* End of 2012 Trust companies co-operate with commercial banks to initiate so-called “BankTrust” wealth management products. real estate developers.000 5.000 4. for example. the CBRC imposed a quantitative ratio on loan type “Bank-Trust” wealth management products.22 February 2013 Trust sector – Now larger than the insurance sector The trust sector had overtaken the insurance sector as the second largest financial subsector in China by November 2012. Specifically. They design trust plans according to commercial banks’ specifications.5tn. the assets under management (AUM) of the trust sector hit RMB 7. By the end of 2012. they design trust plans.000 6. Commercial banks raise funds under their brand and use trust companies to funnel capital to the counter party in the form of trust loans without touching the official loan quota shown on banks’ balance sheets. trust companies play the passive channel role. Trust companies are the organic unit of the trust sector. Credit Suisse 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 Source: China Trustee Association. Through this type of operation. commercial banks decide where the funds will be channeled to. for example. Exhibit 15: … and overtook the insurance sector as the second largest financial sub-sector 7. 2008 and 2009 figures are numbers reported by local press. and allocate the capital into different asset classes. Regulators were also aware that such an operation could affect the quantitative credit quota they imposed on commercial banks: in August 2010.000 1. It is not hard to see the shadow banking nature of this type of operation.000 7.000 Rmb bn * 2007. Such measures did help to correct shadow banking activities of this specific type. figures for 2010 onward are released by China Trustee Association. Exhibit 16 shows the setup of the trust sector.000 3. Local Press. 11 . WIND. commercial banks have turned their wealth management product window into a secondary loan department providing credit to counter parties that would otherwise not have been able to obtain credit. Exhibit 14: Trust sector’s AUM jumped 8.

both in terms of other single-unit trusts and collective-trusts. This type of operation usually offers little disclosure and there seem to be less regulation. Assets under single-unit trusts were RMB 2.9tn in 2012cQ4. China: Shadow banking – Road to heightened risks 12 . usually the principal determines the destination of the funding. given the surge in size. “Bank-Trust” products provide reasonable disclosure and their growth has been largely monitored.22 February 2013 Exhibit 16: The basic structure of the trust sector Source: Credit Suisse But the trust sector continued to grow through other forms of operations. These uncertainties fuel the concern about the underlying risk. Assets under collective-trusts were only at RMB 479bn in 2010cQ3.1tn in 2012 Q4. the secondary source of funding is less certain. Although the direct principals of single-unit trusts are said to be institutions and high net-worth individuals. Single-unit trust refers to trust operations in which the principal that the trust company faces is a single entity. It was other operations that drove the AUM of single-unit trusts to double in just eight quarters. With the regulatory constraints.3tn in 2010 Q3. “Bank-Trust” partnership is a single-unit trust in which the bank is the single dominant principal making use of the channel provided by the trust company. and the amount reached RMB 5. while the trust company plays a passive role. and the amount reached RMB 1.

The involvement of commercial banks in trust funds also goes beyond the now monitored “Bank–Trust” products.” Effectively. Credit Suisse China: Shadow banking – Road to heightened risks 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 Trust companies play a proactive role in originating collective-trust products. such an operation goes beyond a generic equity investment. the “funding pool” held by commercial banks could easily go into single-unit trusts subsequently funneled through various shadow banking activities. for example. it is more like providing loans to the counter party without going into the trust loan channel.RHS 80% 70% 60% 50% 40% 30% 20% Source: China Trustee Association. information asymmetry may lead investors to hold the perception that commercial banks would be responsible for the products sold at their branches. fund raiser and fund manager. Little transparency in both the single-unit trust and banks’ “funding pool” hinders our ability to provide an empirical description of this type of operation. . we see the thirst for funding from public projects and real estate developers as boosting the growth in collective-trusts.LHS "Bank-Trust" AUM as % of single-unit trust AUM RHS 90 80 70 60 50 40 30 20 10 - Exhibit 18: Large proportion of funds raised by collective-trusts went to infrastructure investment and property sector 120 100 80 60 40 20 Monthly new issuance(RMB bn) . But indeed. Behind the surge of other types of single-unit trusts. Or from the other angle. and in 2012 its share reached 25%. This highlights that the trust companies have taken a more proactive role in the trust fund industry. But many products of this kind have the hidden element of “purchase and sell-back. Although commercial banks are not contractually involved. The short-term investment element may appear to be less relevant to shadow banking. The AUM of collectivetrusts has also taken up a much higher proportion of the total AUM of the trust sector. We see the booming collective-trust operation as helping to provide funding to public investment projects and real estate sectors. but we believe they are worth highlighting as well. from 16% in 2010. the counter party that needs to raise funding uses its holdings of securities as collateral to borrow from the trust company with a pre-agreed interest rate. but also the originator of the trust operations.LHS Infastructure & Property as % of total new issuance . It is common for trust companies’ collective products to be sold to high street investors at commercial banks’ branches. The growth in the size of collective-trusts is more than four-fold from 2010 Q3. Credit Suisse Dec-08 Jun-09 Sep-09 Dec-09 Jun-10 Sep-10 Dec-10 Jun-11 Sep-11 Dec-11 Jun-12 Sep-12 Dec-12 Mar-09 Mar-10 Mar-11 Mar-12 13 . Exhibit 18 shows that more than 60% of the funds raised by collective-trusts went into the infrastructure and property sector in recent months. Clearly. And over the four-fold growth period. in which they act as the trust plan designer. They now are not only the channel. Short-term investment in equities is one of the popular vehicles of trust fund short term investment. Market participants pay less attention to other asset classes held by the trust sector. we believe commercial banks’ role is unclear. but details of these types of products might point to the opposite.22 February 2013 Exhibit 17: Other single-unit trusts pushed up the growth of trust sector after CBRC’s regulation on “Bank-Trust” partnership 6000 5000 4000 3000 2000 1000 0 AUM by single-unit trust (RMB bn) . such a 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 Source: Use – Trust. on average 50% of the funds were given to the infrastructure and property sector directly.

Source: People’s Daily. indeed. and they would likely be forced to help stem the potential impact. domestic creditors were generally not exposed to principal haircut in the debt resolution. and on average more than 65% of the haircut was taken by foreign creditors in the bankruptcy. a state owned international financing and investment vehicle. it is unlikely that banks could operate unscathed. In 1988.22 February 2013 lack of transparency highlights the potential risk behind the booming single-unit trust. by transferring local government revenue streams to meet the requirements for corporate bond issuance. Exhibit 19 gives a brief summary of the story. LGFVs are corporates created by local governments. after the new issuance rose sharply in the second half (Exhibit 21). and their accounting ratios are achieved. It is not true that Chinese trust companies or state-owned financing vehicles never run into insolvency. We believe the resolution of insolvency. bad debt and cash-flow problems arose. a series of state-owned trust companies and local government financing companies in Guangdong went into insolvency after the Asian financial crisis hit China in 1998. with the exception given to pilot programs run by Shanghai. But the concern is with the infrastructure-related and local government financing vehicle (LGFV) bonds issued in the corporate bond market. Many local government trust companies and local government non-bank financial corporates went into insolvency and could not meet their repayment obligations. With the purpose of raising funds to support public spending projects. Today’s rise of trust fund products is not paralleled in history. Shenzhen. “ Integrating China: Towards the Coordinated Market Economy” by Peter Nolan. Local governments in China cannot issue bonds.000 trust companies in China. Guangdong International Trust & Investment Corp. The PBoC and Guangdong government provided funding to help the debt resolution programs that were under the charge of Wang Qishan. if it were to happen to this wave of trust funds. would be very different and a lot more complicated than the story summarized below. Guangdong and Zhejiang. But the number shrunk to around 80 in 2002 after rounds of regulatory changes. Indeed. With the relatively healthy fiscal conditions of Guangdong government. China: Shadow banking – Road to heightened risks 14 . as reflected in Exhibit 20. and in terms of the degree of exposure held by high street investors. filed for bankruptcy in 1999. Credit Suisse Corporate bond market − the key issue is local governments The development of the corporate bond market per se could have been viewed as a positive development for China’s capital market. Today’s social-political environment as well as macroeconomic environment are very different from that after Asian financial crisis. The deep involvement of commercial banks leads us to believe that in the case of a default of trust funds. It was reported by official sources that the amount of outstanding debt from various types of local government trust companies and agriculture financing platforms was around RMB 100 bn or 11% of Guangdong’s GDP at that time (market sources reported the amount was at around RMB 200 bn or 22% of Guangdong’s GDP). GITTC mainly borrowed from foreign investors. for example. the funding support from the PBoC. there have been several growing waves of trust companies since the opening and reforms in China. It is not the first time that we have seen a rise in the trust sector. Exhibit 19: The insolvency of Guangdong local governments’ trust companies in late 90s – A story that took place not such a “ long long time ago” When Asian financial crisis hit Guangdong in 1998. Vice-Governor of the province at that time. there were more than 1. Their outstanding amount increased by RMB 800bn in 2012.(GITTC). and the principle pursuit of social stability. especially in terms of variety and degree of complexity in the product structures. But local government financing vehicles issue corporate bonds for their financing needs. Other state-owned trust companies and financial corporates went into insolvency at that time and had borrowed from domestic investors as well.

Exhibit 20: Outstanding LGFV bonds doubled again last year 2000 1800 1600 1400 1200 1000 800 600 400 200 0 Outstanding LGFV bonds (RMB bn) Exhibit 21: … with new issuance rising sharply 350 300 250 200 150 100 50 0 New issuance of LGFV & Infrastructure investment related bonds in the quarter (RMB bn) 2012Q4 2012Q3 2012Q2 2012Q1 2011Q4 2011Q3 2011Q2 2011Q1 2010Q4 2010Q3 2010Q2 2010Q1 2009Q4 2009Q3 2009Q2 2009Q1 2008Q4 2008Q3 2008Q2 2008Q1 2007Q4 2007Q3 2007Q2 2007Q1 Source: WIND. We believe the growth of the bond market is a positive development for China’s financial sector. In this sense. for example. are also substantially exposed to the LGFV bonds by taking them into their asset pools. Credit Suisse 15 . they become local governments’ shadow financing source. Effectively. hitting RMB 1. A key distinction between infrastructure projects and usual industrial projects is that the capital expenditure for the former is much higher and it takes much longer to generate returns. And their outstanding amount almost doubled once more. the current implicit local government guarantee corporate bond situation leaves plenty of uncertainties. Subsequently. Credit Suisse China: Shadow banking – Road to heightened risks 2004 2005 2006 2007 2008 LGFVs’ financial ratios are often made to meet the requirements necessary to access the corporate bond market. more recently. new issuance of LGFV bonds jumped. by transferring large amounts of local government land to an LGFV to increase the asset base. and there is no explicit guarantee from local governments. we view these as implicit local government guarantee bonds.22 February 2013 Policies that favour the corporate bond market were launched in the 2007/2008 era. The strong relationship between other players in the shadow banking system and LGFV bonds further complicates the matter and adds to concerns about the potential systematic risks. Systematic risk concerns then formed. Once again.8tn. But without a formal and properly regulated municipal bond market. as public spending and infrastructure projects were used to drive the stabilisation of the economy. issuance of LGFV bonds rose sharply as shown by the almost vertical line at the right end of Exhibit 21. reflecting the uncertainty on the part of investors. trust funds and banks’ funding pools. local governments have to use their own fiscal capacity to subsidise LGFVs in order to meet their credit obligations. Other shadow banking activities. And there was little LGFV bond issuance at the beginning. 2009 2010 2011 2012 Source: WIND. and although they are classified as corporates. forming around 25% of total corporate bond financing. We believe there is regulatory uncertainty regarding some of the methods LFGVs employ to boost their financial ratios in order to raise more funds. and their outstanding amount doubled in 2009. and investors’ ratings on LGFV bonds are often lower than the agency rating. for example. Yet there is little information available to investors regarding local governments’ financial conditions. So LGFV bonds are often issued with a higher yield. when funding needs from local governments became apparent after the RMB 4 trillion package in early 2009. many LGFV bonds with lower ratings stay on commercial banks’ balance sheets rather than being diversified out. Therefore. But soon. we might say that LGFV bonds became a direct bank-local government credit channel on top of the loan channel. These methods have negatively affected the credibility of LGFV bonds.

“Bank-Trust” products were typically associated with trust loans before the quantitative constraint. 2004 2005 2006 2007 2008 2009 2010 2011 2012 China: Shadow banking – Road to heightened risks 16 .22 February 2013 Commercial bank wealth management products The debate about commercial bank wealth management products was intensified by the comment from Xiao Gang. Exhibit 22: Commercial banks’ wealth management products have boomed 35.000 20. These partnerships are often used to facilitate the shadow banking activities.000 25. commercial banks are not only the fund raiser. In most of the joint wealth management product operations. Commercial banks often play the dominant role in determining the destination of the funding rather than assigning the fund manager role to their partners.000 3. The now regulated “Bank-Trust” partnership described above is one type of wealth management product.0 10.0 15.0 0. of new bank wealth mangement products issued during the year . Exhibit 23 gives a snapshot of bank wealth management operations. Credit Suisse Commercial banks initiate wealth management products independently as well as jointly with other financial intermediates. currently the CEO of the Bank of China.000 0 2.0 6. WIND.0 1.LHS 8.0 Source: CBRC.000 4.RHS No.0 5. In a piece published in the China Daily (on 12 October 2012). he described the commercial bank wealth management product as a “Ponzi Scheme”.000 5.000 30. and the currently booming “Bank–Broker” partnership also belongs to this type.0 Amount of outstanding bank wealth management products (RMB tn) . but also the underlying initiator.0 7. “Broker-Trust” products are often associated with the transfer of discounted banker’s acceptance bills from commercial banks’ balance sheets to off-balance sheet to free up the quota constraints.

. the amount was RMB 500bn. then the burden on commercial banks would be likely to be substantial and the subsequent impact on real economic activities through balance sheet. investments in the pool. Fitch reported the total size at RMB 14tn. and the asset. in this type of “Funding Pool”. Besides the mis-match issue. Funding raised by different wealth management products is then subsequently pooled together in a “centralized” fashion with little transparency on the investment management details of this pool. But in 2007. commercial banks issued new wealth management products to pay off the repayment due to investors holding the expiring wealth management products. we believe the assets held in the pool are also a cause of concern..22 February 2013 Exhibit 23: Bank Wealth Management products – a snapshot Source: Credit Suisse Commercial banks also initiate “Funding Pool”. Described by Xiao. The generic problem of this type is that there is no match between the liability. If the funding flow from new investors suddenly stopped.e. It may be an over-exaggeration to claim that all of the outstanding banks’ wealth management products are exposed to excessive risk and that certain proportions of this total amount were also accounted for in the trust sector’s AUM or other sectors’ AUM. The total size of outstanding banks’ wealth management products was RMB 7. the wealth management products sold and held by investors. according to the CBRC. prorogating the systematic risk to the economy. Moreover. credit and liquidity channels should not be underestimated. The substantial growth in the size of the banks’ wealth management products is apparent and the potential systematic risk is apparent to us. for example. and different sources tend to adopt different definitions.e. If a credit or liquidity event hit. and the funding pool can be used to conduct all types of shadow banking activities to provide credit to counter parties that would have otherwise been ineligible to obtain loans through normal channels. these products are widely spread to high street individuals. China: Shadow banking – Road to heightened risks 17 . then the investment would probably collapse. The lack of transparency brought challenges to the accounting of the total size. Banks issued different commercial products with specified maturities and expected yields without specifying details of the underlying investments. There is little disclosure on the assets invested by the funding pool. i. that is fifteen-fold growth in five years.6tn by the end of 2012. i.

Exhibit 24: A simple form of shadow banking activity by broker asset management Source: Credit Suisse But details may show plenty of grey areas of broker asset development.22 February 2013 So all the big guys are in? Asset management by brokers is currently the area that is seeing the highest growth. the sector was growing at RMB 10bn per day. the discounted banker’s acceptance bills on the banks’ balance sheets are transferred to the fund managers’ books. in our view. or in other words. the size of securities companies’ assets under management reached RMB 1. and regardless of which financial intermediates played the key role in facilitating the activities. The size doubled within a quarter. Regulators continued to respond to the dramatic growth by imposing new regulations. by the end of 2012 Q3. It was reported by the local press that currently 80% of broker asset management activities are channelling types of shadow banking activities. channel fee. brokers here are barely used as anything other than a channel for commercial banks to free up the imposed loan quota constraints. Such an operation would free up the banks’ balance sheet. It has been widely reported that broker asset management may again be used as a channel for shadow banking activities.9tn by the end of 2012. And not surprisingly. albeit low. the dramatic growth is the common feature among all of the operations. While cash stays with the banks. there have also been news reports regarding possible tightening of these type of shadow banking activities by brokers. Banks raise funds through their WMP windows and the brokers are assigned the fund manager role on paper. and brokers capture some. We think the supportive policy in favour of broker asset management that was announced in October directly helped such a boom. According to the China Securities Association. Rather than being a conventional asset manager pursuing the goal of maximized return and minimized risk. China: Shadow banking – Road to heightened risks 18 . new types of operations were developed. What is notable is the growth rate. the size was only RMB 930bn. Exhibit 24 gives an illustration for the simplest type of “BankBroker” shadow banking operation. but soon. No matter the type of shadow banking activity.

Issuance bank will not touch explicit quota. Leaves room for moral hazard problem. Often involved Small and Medium size Enterprises. 1.. Propagates the booming “ Bank-Broker” shadow banking activities which facilitate the off-loading purpose. It was reported by CCTV that. Wenzhou’s issue fuelled a round of concern over the Chinese economy. i. Bank that discounts the bill has to take the discounted bill on its balance sheet. 3. given the dramatic growth in the broker wealth management product. The current issue with corporate bond is the bonds from the large amount of issuance from the local government financing vehicles. 3. Credit Suisse China: Shadow banking – Road to heightened risks 19 . 2. non-market-based interest-rate setting. there was on average 56 related to underground lending court cases per day in Wenzhou city. banks may take on an active middle man role. These are implicit local government guarantee bonds. 1. Entrusted loan is not subject to the loandeposit ratio. for the first 7 months in 2012. A channel that banks use to provide short term finance. Collateral is usually specified in the trust plan. which probably means that bridges can be established for another big player to join the shadow banking activity. 5.Associated with very high interest rate. The bank acts a channel to complete the loan transaction.4. Wenzhou is the place most known for underground lending.22 February 2013 We believe it is not hard to predict that. 5.” Policy in favor of asset management by the insurance sector was promoted recently.3. 4. they become local government’s shadow financing channel. the debt chain broke down and parties involved in underlying lending went into insolvency. 1. This is an off-balance sheet item. Trustee (Trust company) according to trust plan to lend funding to third party in the form of loan.e. 2.3. 1. as economic headwinds hit the manufacturing hub. 4. 5. it is not subject to the loan-deposit ratio that governs commercial banks . 3. Black market of lending and borrowing without direct involvement of formal financial institutions. Given the structural factors behind issues such as the banking oligopoly. Appendix: Explanations of often-quoted terms Trust Loan: 1. 2. 3. Entrusted Loan: Banker’s Acceptance Bill: Corporate Bond Issuance: Underground Lending: Source: PBoC. 2. Local Press. Principal owner specifies the counter party and details of loan to provide the funding through a bank. This motivates the banks to transfer them to off-balance sheet. 5. 4. governmentoriented fixed asset investment driven growth. also pushing some minor reforms to the local financial system. Under the name of corporate. we also expect new types of operations to be developed under any new regulations. regulators will launch some new measures toward some of the “grey areas. Bank should play a passive role. occupying the quota. Development of corporate bond market per se is positive and is critical for the development of the capital markets in China.

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