China faces hidden risk of 'shadow finance' led financial crisis

It appears that China is going to experience its version of the 2008 structured finance meltdown that almost brought down the global financial system.  The Wall Street Journal carried an article that highlights how loans made by China's opaque shadow finance sector may be coming back to haunt its banks.

The solution for China, just like it was and is for shadow banking in the EU, UK and US, is to bring transparency to the shadow finance sector.

Specifically, China should require that there be observable event based reporting for all activities like a payment or delinquency involving the underlying loans before the beginning of the next business day.

With this disclosure, investors could independently assess the risk of the loans and would know what they own.

Mr. Wang's case highlights the hidden risks to banks from their links to China's fast-growing "shadow-finance" industry, a term for all types of credit outside formal lending channels. 

Shadow finance in China totals about 20 trillion yuan, according to Sanford C. Bernstein & Co., or about a third the current size of the country's bank-lending market. In 2008, such informal lending represented only 5% of total bank lending. 

China's shadow-finance industry has experienced similar growth to the global shadow banking system in the years leading up to the financial crisis.

The sector is lightly regulated and opaque, raising concerns about massive loan defaults amid a softening economy, with ancillary effects on the country's banks. 

Just like the shadow banking system, China's shadow-finance industry is lightly regulated and opaque.  As a result, no one knows what is going on.

Banks often work with private lenders by selling loans to them or marketing investments on their behalf for a fee. 

"Regular banking and shadow banking are not isolated from each other. Many activities in the two systems feed into each other, and could influence each other if things start to deteriorate," wrote Xiao Gang, chairman of Bank of China Ltd., in an editorial in the China Daily newspaper. 

Although China Credit has the legal responsibility to repay investors, according to Chinese law, "for reputation's sake and potential social stability reasons, a portion of these loans can be banks' contingent liabilities," said David Cui, China strategist with Bank of America Corp.'s BAC -0.66% Merrill Lynch unit. 

Just like the shadow banking system, nobody knows what the exposure of the regulated banks are to the shadow banks.  As a result, nobody knows if the regular banks are solvent or insolvent.  This sets the stage for a systemic financial crisis.

Others agree. "Banks might be held liable if bank representatives didn't adequately evaluate the products' risks for their clients," said Peng Junming, a former official at the People's Bank of China who now runs his own investment firm, Empire Capital Management LLP.

With opacity and a lack of observable event based reporting, it is impossible for the banks to have adequately evaluated the products' risks for their clients.

Just like shadow banking leading up to the beginning of the financial crisis, China's version of shadow-finance is a powder keg ready to blow up.