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China’s biggest banking problem has long been a lack of risk taking. Bankers have lavished loans on state-owned enterprises, believing the government will back them up, and shied away from the hurly-burly of the private sector.

But a tipping point of sorts has been reached this year, showing risk is on the rise in the Chinese banking sector – for the better and for the worse.

Since July, for the first time ever on a consistent basis, non-bank institutions have been as big a source of financing as banks themselves. That has ensured that credit growth in China has remained strong even though the government has put a cap on lending by banks. The ratio of total credit-to-gross domestic product in China has risen this year to more than 190 per cent from roughly 175 per cent in 2010 and 2011.

“This development is a double-edged sword,” says Simon Ho, a banking analyst with Citi.

“Ample credit growth means a non-performing loan shock is unlikely [because companies can access financing], but the rapid growth of credit [is coming] through less regulated and opaque products.”

The biggest alternative provider of credit has been trust companies – a corporate structure which combines aspects of private equity firms and hedge funds. Trust company lending rose by more than 40 per cent this year, compared with just a 15 per cent increase in formal bank lending.

The corporate bond market has also grown very quickly, emerging as another key alternative source of financing. It is possible to put a positive gloss on this – it heralds an important change from the traditional pattern of about three-quarters of China’s financing coming through the bank sector.

“The booming bond market reflects the government’s promotion of direct financing, which should reduce the reliance on the banking system, diversify risks and improve the efficiency of resource allocation,” Jian Chang, an economist with Barclays, wrote in a recent note.

But the International Monetary Fund said in its global financial stability report in October that the corporate bond market in China bore some of the same characteristics as the murkier shadow banks: high returns and artificially suppressed default risk.

“Underpinning demand is a record of zero bond defaults matched by remarkably high credit ratings,” the IMF wrote. It noted that 98 per cent of rate bonds are AA or higher.

The Chinese onshore corporate bond market has yet to experience a default, with local government bail-outs protecting companies such as LDK Solar which were on the brink of trouble. The shadow banking sector, though growing quickly in China, is still much smaller than its equivalent in developed economies in the run-up to the global financial crisis. But exposure to the shadow assets in China is very broad because banks themselves have become the main channel for their distribution.

Banks have been fighting for customers by marketing what are known as wealth management products – deposit-like instruments that offer yields about 150 basis points higher than ordinary savings accounts. These returns are achieved in large part by directing the customers’ funds into the shadow banking sector, though with only the most minimal of disclosures.

A reminder of the risks inherent in such activity came in early December when Hua Xia bank, one of the country’s most aggressive distributors of wealth management products, blamed an employee for issuing a product that might not be able to repay investors.

Hua Xia said the products were backed by assets from a pawn shop and a car sales company in the poor central province of Henan.

That, however, is an isolated case and regulators say they are confident that they have a handle on the risks. “Unlike in some foreign countries, most financial activities by non-bank financial institutions in China come under supervision,” Zhou Xiaochuan, central bank governor, said in November.

But with the shadow banking sector expanding so quickly in China, regulators have their work cut out in staying on top of it. When regulators took steps, for instance, to slow the growth of trust companies in recent months, financing flowed instead to securities brokerages.

It turned out that securities brokerages, stung by a weak stock market, were only too eager to follow the trust model by packaging high-yielding loans into investment products. As a result, assets under management in the securities sector have more than tripled from Rmb282bn ($45bn) at the start of the year to Rmb930bn at the end of the third quarter.

The fact banks themselves are the main intermediary between investors and non-bank institutions raises the question of just how many of the shadow products might eventually wend their way back on to bank balance sheets.

“Wealth management products and trusts sold via banks may be perceived as having little more risk than bank deposits as it is generally believed that everything will be taken care of by banks and/or the government,” Wang Tao, an economist with UBS, wrote in a recent note. “In the end, social pressure may indeed force banks to shoulder the risk and any losses.”

So, while credit flows in China are more diversified than in the past, the buck is still likely to stop with the banks.

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