Licence to kill: why a 0.007% yield could be dangerous

If you want a barometer to gauge storminess in financial sector sentiment, you could do worse than look at one of the most prosaic of funding mechanisms for the global economy: a centuries-old trade finance product called a banker’s acceptance.

Comparable with other devices used to grease the wheels of trade — supply chain finance, factoring, invoice finance, letters of credit — banker’s acceptances are designed to be as safe as they are dull. They are collateralised, short-term payment promises guaranteed by a bank and rendered liquid by being tradeable on an exchange. A stable, predictable market should be a given.

But as Lex Greensill showed, even a mundane financial product can be turbocharged into something that bears little resemblance to the original concept, hides risk off-balance-sheet and causes billions of dollars of losses to investors who don’t pay attention. Just ask Credit Suisse, now embroiled in a web of legal claims from clients which had funds invested in Greensill’s “innovative” take on supply chain finance.

For years, China’s banks and the broader Chinese financial sector have been innovating in a not dissimilar way with banker’s acceptances. According to CEIC Data, China’s banker’s acceptances market was worth Rmb3tn late last year, down from a peak of close to Rmb8tn in 2014, but still vast and a key part of the shadow banking activity that China has relied on to fuel its growth.

Shadow banking as a proportion of China’s overall financial activity has grown dramatically in recent years. It now accounts for more than 60 per cent of GDP, compared with next to nothing before the global financial crisis, according to research published by the Manchester School and Wiley. That puts it ahead of the UK, where shadow banking has also grown in importance, but equates to barely half of GDP.

Shadow banking products are many and varied, but the bulk of them in one way or another short-circuit mainstream banking regulation. Banker’s acceptances have become an important way for Chinese banks to comply with government diktats on lending, since they count as loans, while avoiding the capital charge of balance-sheet lending.

A number of issues pose potential concern. Banker’s acceptances can be used as the archetypal alchemical off-balance-sheet cash generator: a bank receives cash via a collateral downpayment from a client in exchange for an off-balance sheet guarantee; it is then able to trade the banker’s acceptance with another bank that might be even keener to boost loan volumes without inflating its balance sheets.

The appeal for banks is clear. But the alchemy works for clients too. Matthew Lowenstein, an analyst at J Capital Research, wrote several years ago about evidence of collusion between regional banks and cash-strapped local governments who used the products essentially to “print their own money”. Today, local governments are again under stress, as their lucrative practice of raising public funding by selling land to property developers has been constrained by Beijing. Suddenly there is a renewed incentive for creative money-printing.

Important safety devices of the original banker’s acceptance formula have been overridden, too. Standard short-term durations of a few months have been routinely rolled over by banks that are loath to end the party. Collateral levels have been lowered. Insufficient checks on the validity of security and underlying trade transactions may also have been facilitating fraud.

A fraud crackdown was launched in 2017, one reason for the sharp dip that year in the issuance of bill financing, such as banker’s acceptances and commercial paper. The problem was far more pervasive than a few fictitious trade deals. A large chunk of loan proceeds was subsequently used to purchase real estate, local experts say. Wealth management products, another shadow banking activity pushed by banks, were also recycled into banker’s acceptances.

A second scare followed in 2019 after Baoshang Bank failed. The interbank funding market seized up, in part because of concerns about fraud and insufficient collateral on banker’s acceptances.

No matter how safe these kinds of products are in theory, they certainly aren’t risk free in practice. Unfortunately, the market is increasingly pricing them as if they were. In China at the end of last month, demand for banker’s acceptances hit a new high, as banks strove to hit government lending targets. The resultant yield: a pretty-much “risk-free” 0.007 per cent.

patrick.jenkins@ft.com