Children look at a map of the Alice in Wonderland Maze at Walt Disney Co.’s Shanghai Disneyland theme park during a trial run ahead of its official opening, in Shanghai, China. (Photographer: Qilai Shen/Bloomberg)

A Guide to China's $9 Trillion Shadow-Banking Maze

(Bloomberg) -- Shadow banking in China is a vast ecosystem which connects thousands of financial institutions with companies, local governments and hundreds of millions of households. Its growth in recent years, fueled by asset management products and peer-to-peer lending, lifted a broad measure of shadow banking assets to an estimated $10 trillion. But then the crackdown came, prompted by a government campaign to tackle risks in the financial industry that might threaten the wider economy. One of the main problems is that regular banks -- unlike in the U.S. -- are major participants, keeping shadow-banking assets off their balance sheets to sidestep regulatory constraints on lending. Already, the shadow-banking tally has dropped to $9 trillion, according to Moody’s Investors Service. Here’s a glossary:

Asset Management Products

The largest funding source for shadow loans, these bear little resemblance to the investments offered by fund managers in London or New York. AMPs are effectively high-yielding deposit accounts offered by banks, brokerages and other financial firms to raise funding from companies, households and even each other. Because of the widespread perception that they’re guaranteed by the issuers, and that the government stands behind China’s financial institutions, AMP issuance has exploded, reaching 100 trillion yuan in 2017. Not all of that flows into shadow banking, but as issuers try to match the over-sized yields promised to depositors, a good-sized chunk has gone into funding loans to weaker borrowers and speculative areas like real estate and stocks.

A Guide to China's $9 Trillion Shadow-Banking Maze

Wealth Management Products

This is the name given to asset management products issued by banks, about 30 percent of all AMPs. As part of the regulatory clampdown, financial institutions have until the end of 2020 to comply with tougher rules aimed both at breaking the idea that AMPs carry implicit guarantees and at suppressing riskier types of lending. China’s biggest lenders have all announced plans to set up wealth-management units in preparation for tougher regulations on the $4 trillion industry.

Entrusted Loans

The No. 2 shadow-banking source, entrusted loans provide a way for cash-rich companies to lend to other firms by using banks as middlemen. However, rather than acting solely as agents, some banks have used the process to make the loans themselves. And because of light regulation, many such loans have gone to risky borrowers like local government financing vehicles or property developers. Regulators have acted, though, for instance stopping banks putting up their own money and enforcing their role purely as intermediaries.

Trust Loans

These are loans provided by China’s 68 trust companies, which invest money on behalf of wealthy individuals but into which banks also channel funds. Again, light regulation meant that loans were directed to higher-risk borrowers who couldn’t get money from banks, and at such a rate that until recently these were the fastest-growing shadow-banking segment. That’s changing. Regulators in December 2017 banned trusts from using bank funds to invest in stocks, property and local government financing vehicles. Squeezed between rules forcing them to boost capital and an asset drop linked in part to new regulations, the sector’s outlook is uncertain. Trust assets under management shrank in the first two quarters of the year to $3.5 trillion, the first back-to-back decline since data became available in 2010.

Internet Financing

Peer-to-peer lending and other internet financing have surged outside the gaze of regulators -- accounting for 9 percent of shadow financing -- but officials are coming down hard. Alarmed by a surge in defaults, fraud and investor anger, authorities are planning to wind down small- and medium-sized P2P lending platforms nationwide, and may also order the largest platforms to cap outstanding loans at current levels and encourage them to reduce lending over time, people familiar with the matter said. More than 80 percent of China’s 6,200 P2P platforms have either closed or encountered serious difficulties. Only 50 of today’s 1,200 platforms are likely to get regulatory approval to keep operating, according to Citigroup Inc. The industry’s outstanding loans have already dropped by more than 30 percent from the peak.

Interbank Funding

Though not a direct source of money for shadow loans, interbank funding is another engine for the industry because it allows smaller banks that lack the branch networks of larger rivals to inflate their balance sheets and sidestep regulatory limits on lending. Interbank funding has also provided a source of leverage for Chinese funds and brokers to invest in bonds, adding to the hidden and risky inter-dependencies in China’s financial system. To address this, China in 2017 imposed a limit on interbank liabilities of no more than a third of a bank’s total liabilities.

Structured Deposits

Faced with restrictions on AMP issuance, banks and other financial firms have turned to products that include yield-enhancing features such as options contracts. For instance, a structured deposit may offer a yield of 5 percent that would be reduced to 1 percent in the event of something -- usually unlikely, if not impossible -- happening, such as the yuan hitting 5 per U.S. dollar within a certain time frame. The practice allows issuers to offer turbo-charged yields that they are often later forced to subsidize. That way they can bypass regulations forbidding banks from guaranteeing returns to investors. Regulators are planning to ban the sales of some structured deposits.

The Reference Shelf

  • China’s $10 trillion shadow bank crackdown has a long way to go.
  • QuickTake explainers on how shadow banking is booming outside regulators’ grip, how China is getting serious about financial risks and China’s war on online loans.
  • QuickTakes on WMPs and entrusted bonds.

©2018 Bloomberg L.P.