Fitch: China's Shadow Bank Reforms Have a Long Way to Go

Recent developments highlight China's efforts at reforming and regulating - but not rolling back - the growth of shadow banking. This process is still evolving, and Fitch Ratings feels that risks may continue to reside away from the spotlight of the regulators. As a result, structural pressures within the banking sector are likely to persist, exposing short-term rates to volatility but keeping them above historical averages.


The onset of these reforms is particularly salient, as China's credit boom is likely to continue beyond 2014 (albeit at a slightly slower pace). Fitch believes that new credit, based on its adjusted measure of total societal financing (TSF), may be a bit lower than the CNY22trn Fitch estimates was extended in 2013. Asset quality will therefore remain a serious concern until the economic return on credit improves.


The key aspects of the reforms are: disentangling banks from wealth management products (WMPs) to ensure appropriate risk taking, and provisioning, on balance sheets; heightening the transparency of trusts and their underlying assets; and limiting credit guarantee companies from taking on too much financial leverage.


At a minimum, these measures are designed to improve banks' loan/deposit ratios and limit the interbank markets' exposure to WMPs. More broadly, these ought to begin addressing contagion risks, as the inter-connectedness between banks and non-banks has risen. Whether regulations will be rigidly enforced and prove effective is not known.


"The reforms may seem like a good beginning, but they have a long way to run. This is because the depth and breadth of shadow banking is still not clear in the absence of exhaustive official data," says Fitch. Moreover, the approach of the principal regulators - the People's Bank of China (PBOC) and China Banking Regulatory Commission (CBRC) - continues to evolve. In addition, risks continue to lurk away from the view - and at times even the jurisdiction - of these regulators.


A considerable amount of credit extension remains outside formal banking channels, hence the CBRC is understandably more keen to raise the transparency and regulation of non-bank credit activity, rather than applying a restriction on volumes. However, a more effective containment of risk may indeed require a stronger clampdown on asset expansion - especially through informal channels - but this is not yet in evidence.


More appropriate risk-taking is also contingent on complementary reforms. For instance, better alignment of local government incentives with their tax-raising and financing capabilities may lower a reliance on local government financing vehicles and shadow banking arrangements.


China's shadow bank reforms will take time to gain traction, and recognition of asset-impairment will be a protracted process. This will manifest itself in eroding liquidity, as cash inflows from borrowers remain under pressure and more resources are directed at forbearance/support. Dwindling cash buffers amplify liquidity risk, and are likely to place structural pressure on interbank rates.


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