Confessions of a Shadow Banker in China: It's the Formal Sector that it at Risk

In an OpEd article at Bloomberg, a self proclaimed shadow banker and author of “Inside China’s Shadow Banking: The Next Subprime Crisis?”, Joe Zhang talks about the exaggerated concerns over China’s shadow banks and of the real culprit behind China’s bubbles.

An excerpt from the article: (bold mine)

One cannot defend a $5 trillion industry with a couple of examples. Two of Wang’s colleagues had been wiped out in the last year after large borrowers defaulted. Several other informal lenders in Hangzhou had ended up behind bars after disgruntled investors accused them of fraud. In recent weeks, news reports have described mass bankruptcies among small businesses that had borrowed heavily from shadow banks at exorbitant rates.

But neither should one condemn all of shadow banking because of stories like these. Shadow banking is well diversified, and serves a legitimate customer base. By and large, it has much lower leverage than banks or corporate China. Losses at shadow banks are often absorbed by entrepreneurs themselves, without affecting the taxpayer.

Even the “wealth management products” offered by regular banks are not to be feared, because they are just deposits, pure and simple, whatever the theoretical distinctions. I buy them myself.

Certainly, the sector could stand to be brought under greater supervision. But many of the regulations already in place are vague and unreasonable. Authorities have never clearly defined something as fundamental as what constitutes “illegal fundraising.” Microcredit operations, like ours, are allowed to borrow from no more than two banks for any more than 50 percent of their equity capital. Why only two banks? Why only 50 percent? These restrictions are arbitrary, and they severely limit our ability to lend to underprivileged customers.

The government and the media are scapegoating the wrong culprit. Shadow banking has flourished in China for one simple reason: financial repression. By keeping interest rates artificially low, authorities have forced savers to search for more lucrative financial products. By favoring banks -- which, in turn, favor state-owned or well-connected private-sector companies with loans -- they have forced small enterprises to seek out people like me and Wang.

Meanwhile, projects that might look sketchy at 9 percent interest rates suddenly look feasible at 6 percent. Under such conditions, traditional banks have steadily lowered their lending standards -- from prime loans to subprime and then to simply silly loans.

Sound familiar? That’s how the 2008 financial crisis began, too. Leaders are right to worry about the possibility of a banking crisis in China. But instead of focusing their ire on shadow bankers, they should raise benchmark interest rates in order to reduce the amount of credit flowing to dodgy loans through the formal banking sector. The threat to China’s financial system is right there -- out in the open -- not lurking in the shadows.

Arbitrary edicts, financial repression via artificially low interest rates which induces clusters of misallocations or entrepreneurial error via the provision of cosmetic profitability to projects that are really unviable and of the discrimination on bank lending policies (previously mentioned here)  by the formal banking sector favoring State Owned Enterprises (SOE) and cronies, all of which contributes to systemic bubbles in the formal sector.

I am not sure if Mr Zhang is aware of it, but his descriptions of the banking and financial political-economic environment seem to fit to a tee the Austrian Business Cycle Theory (ABCT). 

Nonetheless it is the natural tendency for any government to look for a scapegoat to elude accountability and responsibility for their actions, as well as, use "market failure" as pretext or an excuse to expand control over society. 

But as the above anecdote has shown, China's shadow banks emerged spontaneously as a result of a repressive regulatory environment and from political interventionism and favoritism.

And China’s predicament looks like a familiar setting but at a much subdued scale to her ASEAN peers.