Submitted by Nicholas Borst via The Peterson Institute blog,
Shadow banks in China come in a variety of forms and guises. The term is applied to everything from trust companies and wealth management products to pawnshops and underground lenders. What surprising is that China’s biggest shadow bank is actually a creation of the central government and receives billions in financing directly from the banks. Even more interesting, this shadow bank recently pulled off a successful international IPO where it raised billions of dollars.
First, let’s deal with the terminology. The “shadow” in shadow banking doesn’t imply nefarious doings, although it frequently involves a bit of regulatory arbitrage. At the most basic level, shadow banking is borrowing funds and extending credit outside of normal banking structures.
So what is this mysterious shadow bank that has such tight government connections? It’s none other than Cinda Asset Management Company, a creation of the Ministry of Finance (MoF) and the beneficiary of a recent 2.5 billion U.S. dollar IPO in Hong Kong. In terms of total assets, Cinda is more than 15 times as large as any of the country’s trust companies.
The normal business of a distressed asset management company (AMC) is not shadow banking. It involves purchasing troubled loans at a discount and trying to collect a higher amount from the debtors. Cinda was one of the four AMC’s created by the central government to bailout the banking sector in the 1990s. The initial round of bad debt purchasing was policy-directed, starting in the late 1990s and lasting through the mid-2000s. In the second half of the 2000s, the big four AMCs began to purchase NPLs from banks on commercial terms and in the process tried to transform themselves into market-oriented businesses.
Over the last three and a half years, Cinda’s business has diverged from this model. In addition to purchasing bad debts from banks and other financial institutions, it has accumulated a vast stock of distressed debt assets directly from non-financial corporations.
These non-financial enterprises distressed assets (NFEs) include overdue receivables, receivables expected to be overdue, and receivables from corporates with liquidity issues.
Why would financial institutions make such cheap loans to Cinda? One possible explanation is that the company’s tight relationship with the MoF makes it a low credit risk. MoF’s support of Cinda has been immense. MoF has allowed Cinda’s corporate tax payments to be used to pay down the bonds it issued to China Construction Bank. MoF also gave Cinda a 25 billion renminbi capital injection with a delayed payback period. The odds that MoF would let Cinda go belly up are exceedingly low.
The other reason that financial institutions might be willing to loan to Cinda on the cheap is that the company has come to play a very useful role for them. Commercial banks face constant pressure from regulators to reduce their non-performing loan (NPL) ratio. The strikingly low reported NPL rates throughout the past several years stands in stark contrast to a slowdown in economic growth and fluctuating credit conditions. Shadow lenders like Cinda play a role behind the scenes in extending credit to companies short on cash who are in danger of defaulting on their bank loans. Having this type of lender of last resort helps banks avoid increases in their NPL ratios. It doesn’t, however, reduce the exposure of banks to these distressed companies as they are still on the hook through their loans to Cinda.
The IPO prospectus of Cinda has made clear that the company has rapidly transformed itself from a traditional distressed asset manager to a provider of emergency financing. Though we lack similar disclosure, it is likely that the other three national asset management companies are proceeding along similar lines. China’s AMCs are an important part of the shadow banking system and an enabler of large-scale regulatory arbitrage.