Moody's: Risks of China's shadow banking sector mitigated by relatively small size and policy support

Moody's Investors Service says China's shadow banking sector exhibits similar risks to its Western counterpart, including spill-over risk to the formal banking system, but it is also more exposed to higher-risk borrowers and sectors.

But these risks are mitigated by the sector's relatively small size compared to China's GDP, and the likelihood of policy support for its key borrowers by the Chinese government (Aa3 stable) if required, says the rating agency.

Moody's analysis is contained in its just-published presentation "Comparing Shadow Banking in the West and China," by Michael Taylor, a Moody's Managing Director and Chief Credit Officer APAC, who was speaking at the 2015 International Summer Conference, hosted by the Research Center on Regulation and Supervision of the Financial Sector (CIRSF) in Lisbon, Portugal on 25 June.

Moody's says that, as shadow systems, both the Chinese and Western systems suffer from a lack of transparency, regulation and official backstops.

At the same time, they exhibit important differences. For example, the Chinese system involves loans to comparatively higher risk borrowers who are underserved by the formal banking sector, including firms in the most dynamic and competitive sectors of the economy, such as small and medium enterprises (SMEs). Lending to these higher risk sectors, when combined with freedom from deposit rate caps, allows Chinese shadow banks to offer investors higher rates than are available on bank deposits.

By contrast, the Western system -- operating through the capital markets -- involves financial instruments with generally lower credit risk than bank loans; meets investor demand for liquid instruments by transforming longer maturity securities into shorter maturity liabilities, and achieves efficiency gains through disintermediation by eliminating the "mark-up" charged by banks.

"China's shadow banks remain relatively small when compared to both formal banks, the country's economy, and compared to the shadow banking sectors in Western countries," says Taylor. "This, combined with a high likelihood of policy support to avoid a credit crunch for the sector's borrowers, reduces the overall level of risk."

With Moody's estimating that shadow banking assets in China reached RMB41 trillion at end-2014, the shadow banking sector in China is equivalent in size to approximately 65% of Chinese GDP, compared to 150% in the US, and 199% in the euro area, at end-2014

Borrowers from Chinese shadow banks are often small- and medium-sized enterprises, and other private sector firms.

The risk here is that these companies could suffer from an interruption to credit supply if problems occur in the shadow banking sector, but at the same time, Moody's believes that--in such a situation--the Chinese government would more than likely step in with support if needed.

Other major differences between the Chinese and Western shadow banking sectors include their structure and financial instruments, says the rating agency. Specifically, the Chinese sector operates through loans rather than securities to meet investor demand for higher rates, and -- as indicated -- channels credit to underserved sectors. By contrast, the Western approach is primarily concerned with maturity transformation, i.e. meeting investor demand for more shorter-term and more liquid securities.

Both sectors are capable of giving rise to systemic risks, although in different ways. For China's shadow banks opaque asset quality and implicit, although uncertain, support creates the risk of destabilizing runs should investors lose confidence in the sector. By contrast, the risks in Western shadow banking are more connected with the length of funding chains and uncertainty about the quality of the underlying collateral, both issues which regulators are now seeking to address.

Finally, both the Chinese and Western sectors increase system leverage and asset-bubble risk.