Chinese Banks Push Back On Shadow Banking Regulations - Expose "Catch-22" For Financial System

In November, we discussed how the post-Party Congress measures to deleverage and crackdown on the worst abuses in China’s credit bubble took an important step forward with the announcement of a new era of regulation for China’s $15 trillion shadow banking and asset management industry. See "A New Era In Chinese Regulation Means Turmoil For $15 Trillion In China's Shadows". In particular, the authorities turned their sights on wealth management products (WMPs).

On the way out are “guaranteed returns” and “capital pools” which had turned the $4 trillion sector into a leveraged Ponzi scheme. We joked that in a “radical and shocking” departure from the norm, financial institutions would have to offer yields based on the risk and returns of the underlying assets. Paying out guaranteed returns with new funds from depositors would no longer be allowed.

Commentators at the time described it as “a new era of regulation” which would lead to tighter risk control and slower but higher quality growth in the Chinese economy, blah, blah. However, our interest was piqued by the implementation date for the new rules. This is slated for the end of June 2019, providing Chinese banks and the entire shadow banking system a grade period to get their house in order. As we suggested.

We can only guess the delay reflects the enormity of the problems discovered by China’s regulators when they finally looked under the hood.

We didn’t have to wait long for confirmation that our cynicism was justified. It turns out that there was a “closed-door meeting” last week during which Chinese banks laid out the systemic risk if the regulators pursue their reform plan. According to Reuters.

Ten Chinese banks have raised strong objections to the central bank’s recent move to tighten rules on the asset management sector, saying it may cause a rush of redemptions among other risks, three sources with knowledge of the matter told Reuters.

Senior executives from the joint-stock banks said during a closed-door meeting in Shanghai last week that the rules would have a big impact on financial markets and could even “trigger systemic financial risks”, according to the sources, who declined to be identified due to the sensitivity of the matter. The executives also said the new rules on removing implicit guarantees for wealth management products (WMPs) could spark liquidity risks and increase market volatility, the sources said late on Thursday.

Unlike the Big Four state-owned banks, the smaller banks have limited scope to increase lending in the absence of WMP funding...and that's ignoring the "black holes" hidden beneath the surface.

In short, the entire Chinese financial system, from depositors to banks to asset management companies, has become addicted to the WPM model. Reforming it will only advance the crystallization of losses and bankruptcies, never mind largescale protests from investors who have always assumed that, somehow, the banks would make good on their promises. On a small scale, the clearest example of the near-impossibility of reforming WMPs without threatening China’s financial system, was the example of Foresea Life Insurance in May this year. This report from Fortune captured Ponzi nature and risk of civil unrest.

A Chinese insurer has warned the country’s regulators of defaults in the billions and possible unrest unless it is allowed to launch new products again. Foresea Life Insurance asked the China Insurance Regulatory Commission (CIRC) in a letter dated Apr. 28 to lift its ban, “in order to avoid inciting mass incidents by clients and localized and systemic risks, producing greater damage to the industry,” reports the Financial Times. It further warned that, with an expected redemption of $8.7 billion this year, the insurer might not be able to meet payouts without selling new products.

The Bloomberg article portrays the feedback they gave to regulators on the new regime as “a rare protest by Chinese bankers as pressure mounts amid a government campaign to de-leverage and de-risk the country’s massive and increasingly complex financial system”. However, it’s much more than that, it’s essentially a plea for the survival on the part of smaller banks. Without large pools of deposits, smaller banks have relied on WMP and other shadow banking conduits for funding. In the absence of guaranteed returns, leverage and fraud, that might not have been a problem.

The new rules will pose a direct challenge to a business model that small- and mid-tier banks have been relying on to drive asset expansion and profit growth, bankers told Reuters earlier. “Every time when the regulators announce tighter regulations it would almost always benefit the large state banks and hurt the smaller ones, because they (the latter) are taking much bigger risks,” said a senior executive at one of the country’s big four state-controlled lenders.

The joint-stock banks, which are unable to compete against large state banks for public deposits, have depended on selling WMPs with implicit guarantee of fixed returns to attract retail funds. In turn, they invest the money they manage into stocks, bonds and non-standard debt assets to generate profit. Bank executives said at the meeting the 28.38 trillion yuan of banks’ WMPs, part of the so-called shadow banking sector, have allowed them to bypass regulatory restrictions on credit expansion and capital constraints.

The problem for Xi Jinping and his cronies is that they left the situation to fester for way too long before attempting to intervene. In an effort to dissuade the authorities, here is Reuters on more warnings from the threatened banks.

If the current draft of the rules takes effect, banks will be forced to offload assets beforehand, including selling bonds, stocks and other liquid assets at a discount and asking clients to repay loans before time, the sources said. “No matter which solution we choose, it will hit financial markets,” they added.

The banks also said rules on strictly limiting bank WMP investments in non-standard debt assets and private equities would reduce their support for the real economy and increase financing costs for companies, the sources said. They also suggested the central bank remove certain rules and extend the transition period for the new rules - currently up to June 2019 - to three years to smooth the impact, the sources said.

…which basically amounts to a “Catch-22” situation for China’s financial system.

Meanwhile, it’s worth highlighting a (very) recent example of fraud in the Chinese banking system which encompassed the WMP sector. Last Friday, the South China Morning Post (SCMP) reported on the 722 million yuan ($109 million) fine – the industry’s biggest penalty - served on Guangfa Bank, the largest bank in Guangzhou city. The bank covered up the default of two bonds issued by phone maker, Cosun Group, which had ben sold on an Ant Financial Holdings’ WMP platform. As the SCMP explains.

Ant Financial and 10 other banks sought compensation for investors from Zheshang Property and Casualty Insurance, which had provided insurance coverage on the debt, only to discover that the insurer had been issued fake letters of guarantee by Guangfa’s branch in Huizhou city. The fraudulent documents were created using counterfeit corporate seals made by branch staff. The case involved as much as 12 billion yuan, as the bank tried to channel money to cover its mounting bad loans and operational losses.

“Guangfa did everything that regulators hate the most,” said Chen Shujin, chief financial analyst at Huatai Securities. “They gave an under-the-table guarantee, and made illegal interbank investments to cover up a non-performing loan.”

The epidemic of fraud across China’s financial system has been obvious for years. The Catch-22 situation faced by the Chinese authorities boils down to a timing preference. With Xi’s position cemented for the next five years, the authorities can bring on the “Minsky moment” adjustment, knowing that the economy can recover by 2022. Or they can postpone it, leading to a truly catastrophic collapse down the road.


3LockBox Mon, 12/11/2017 - 23:44 Permalink

"On the way out are “guaranteed returns” and “capital pools” which had turned the $4 trillion sector into a leveraged Ponzi scheme."Sounds like that other sector that starts with a "B" that seems to be posted just about half the time on ZH now.Give me a B, Give me a T, Give me a C...What's that spell? LOUDERWhat's that spell? LOUDERI can't hear you!YEAH!

ds Tue, 12/12/2017 - 00:02 Permalink

The middle class provides the stability to the nation and the Party knows it. The middle class has more debts than savings and where the debts are concentrated in their properties. Whatever savings they have are more with the State Owned Banks than the provincial banks. The middle class is not a gaming class and will not bat an eyelid if speculators in WMP get the hits. They deserve it despite warnings from the Govt and their fading memories of the ponzi small banks that have been part of their personal banking history. This is augmented by the healthy distrust of the Govt to bailouts. Ask their parents on how their pensions had been pillaged. The dog eat dog culture will have no massive unrests and the Party knows it. Provincial Governors are now beholden to Beijing and their promotions depend on no massive unrests. They have regulations in place to force mergers of provincial banks as well as RTCs to buy their WMPs with haircuts directly from the speculators. PBOC statistics on household debts, household savings, bank deposits of the SOE Banks and the provincial banks; their growth, etc are all available to support the above. If you believe that the CB's stats are fakes, then no need for any further dialogs.This article uses selective stats and anecdotes. Not that the shadow banking system is not a problem. It can be wound down without a national economic implosion in State controlled economy. 

old naughty ds Tue, 12/12/2017 - 03:52 Permalink

looking at the bright side is never problem for almost all of us (me2)...but the "dark entity" isn't among us, and the agenda is to collapse, plunder moar, slave-harvest !!!So you think putting  off drills till after ooooo-game is co-incidental to putting off effective day to 2019 ?All playing the same game, waiting, for "instruction".

In reply to by ds

Batman11 Batman11 Tue, 12/12/2017 - 04:53 Permalink

Why was Glass-Steagall so effective?1929 – before Glass - Steagall2008 – after Glass – SteagallGlass-Steagall separated the money creation side of banking from the investment side of banking. It also stopped the money creation side of banking from trading in securities.When the money creation side of banking can only trade in real assets there are limits on its money creation.When the money creation side of banking can trade in securities produced by the investment side, the sky’s the limit and only dependent on the ingenuity of investment bankers in coming up with new securities. They got to work producing CDO squareds, synthetic CDOs, etc .... knowing there was a ready market that can create money out of nothing.The banks buy the securities off each other with money they create out of nothing and you have a ponzi scheme. data shows the 1920s investment bankers were more ingenious and creative leading up to 1929. Look at them go.Someone tell the FED.

In reply to by Batman11

Batman11 Batman11 Tue, 12/12/2017 - 05:04 Permalink

The FED has 220 PhDs in economics, but they all were missing that same critical piece of information, banks create money through loans. is going exponential just before 2008, a credit bubble is underway (debt = money).Knowledge of money, debt and banks has been regressing since 1856, when someone worked out how the system really worked.Credit creation theory -> fractional reserve theory -> financial intermediation theory“A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner you know how banks work regulation becomes simple.Bank credit (lending) creates money.The three types of lending:1)    Into business and industry - gives a good return in GDP and doesn’t lead to inflation2)    To consumers – leads to consumer price inflation3)    Into real estate and financial speculation – leads to asset price inflation and gives a poor return in GDP and shows up in the graph of debt-to-GDPRichard Werner explains in 15 mins: tell the FED, the Basel rules won't work as they are based on financial intermediation theory. 

In reply to by Batman11

anonymike Tue, 12/12/2017 - 05:29 Permalink

There are no government solutions, and no solution for central government, other than their self destruction. Whatever central governments do will only make the situation worse, including the Chinese economy. It will collapse, along with the government.The only constructive path to help future generations is to do everything possible to expedite the collapse and self-destruction of government with their fiat systems. Starve the beast of funding and respect.

Let it Go Tue, 12/12/2017 - 08:12 Permalink

China is no small underdeveloped backwater with an insignificant economy and it is important to remember that "what happens in China does not stay in China." The financial missteps in China have continued and it will only be when their economy falters that we will learn to what extent or hear more stories about how they have masked their problems.The Chinese economy has "been very reliant" on government stimulus, rapid credit growth and the flow of newly created money from a loose monetary policy. We should remember China is far from transparent and the risk remains out of sight. The simple fact that we have become complacent over our concern and that it has yet to develop into a catastrophe doesn't mean it is no longer a danger or valid. More on this subject in the article below. http://China's Financial Missteps Continue.html

gdpetti Let it Go Tue, 12/12/2017 - 11:37 Permalink

Sounds like our system... hard to tell the difference, except that they have something to show for the excess and we don't... .unless you are a member of the club here, with access to free money.... get it while it lasts. China will just change the model... it's these banksters in China that will face the next wave of the ongoing corruption fight... which will help Xi push his control further and deeper into the Party. Remember that Xi has a plan to expand, we don't, ours is only to 'bring down the house'.

In reply to by Let it Go