Shadow banking still a negative credit issue for Chinese banks

Shadow banking products reached RMB21t in 2012.

Moody's Investors Service says that China's latest regulatory steps to tighten controls on wealth management products (WMPs), part of China's shadow banking market, are credit positive for banks, while Moody's expects the issue of shadow banking to continue to weigh on the banks' credit profiles.

HEre's more from Moody's:

"Ultimately, the impact from shadow banking on banks will depend on the amount, timing and allocation of potential losses, variables that are difficult to assess at this point, given the lack of transparency and the fast-evolving nature of shadow banking in China," says Bin Hu, a Moody's Vice President and Senior Analyst.

"We recognize that, even in more advanced economies, shadow banking remains a key channel of credit intermediation that complements the formal banking system. Its growth in China has provided borrowers who have limited or no access to regular bank loans with an alternative source of funding, thus reducing potential pressure on banks to finance less credit-worthy segments of the economy.

"Nonetheless, we reflect shadow banking as a negative credit issue in our analysis of Chinese banks. In our view, the opacity associated with shadow banking products and the threat of loss and contagion outweigh their potential benefits of diverting riskier borrowers from the formal banking system," adds Hu.

Hu was speaking on the release of a new Moody's report, titled, "Risks to China's Lenders from Shadow Banking: Frequently Asked Questions."

The report notes that China's banks have significant exposures to shadow banking activities, through (i) their involvement in the structuring and marketing of WMPs, and (ii) their lending to companies and individuals that are active in shadow banking.

Among the key themes examined in the report are what constitutes a shadow banking market, the size of China's market, the drivers behind its growth, the role of WMPs, the risks to the banking system, and recent steps to impose some form of regulation.

The report estimates that core Chinese shadow banking products -- those that are relatively non-transparent, loosely regulated, and carry elevated credit risk -  totaled a large RMB21 trillion at end-2012, or 39% of 2012 GDP.

To gain a wider perspective on potential risks, Moody's considers it prudent to also monitor a wider range of instruments that facilitate non-bank credit extension. This broader approach to shadow banking leads to an estimate of RMB29 trillion (55% of GDP) in products at end-2012.

Shadow banking involves credit intermediation outside the regular banking system, which allows borrowers to circumvent banks' formal underwriting standards. As a non-transparent and less-regulated form of credit extension, shadow banking can stoke asset bubbles and may pose risks to financial stability.

Illustrating these risks, some large European and US banks sustained severe losses in recent years from exposures to subprime lenders, structured investment vehicles, sponsored money market funds, and other off-balance sheet conduits, all of which are examples of shadow banking.

Accordingly, Moody's believes shadow banking poses continuing risks to banks in many systems, including China, particularly when experiencing rapid growth.

Expansion of China's shadow banking market has been fast, and Moody's estimates the growth rate of core and broad shadow banking activities in China to have exceeded a cumulative 75% and 67% over the past two years, respectively.

This high growth partly reflects tighter credit conditions in the formal banking sector, as well as banks' efforts to manage their loan-to-deposit and capital ratios. Regulators have implemented several measures to tighten controls over shadow banking, but the sector's growth has so far persisted.