China’s Cabinet Imposes New Rules in Shadow Banking Fight

China’s Cabinet imposed new controls on the multi-trillion-dollar shadow-banking industry with an order that targets off-the-books loans and shores up enforcement of current rules, three people familiar with the matter said.

The rules include a ban on transactions designed to avoid regulations, such as moving interbank loans off balance sheets to reduce reported levels of lending, said the people, who asked not to be identified because the order hasn’t been made public. Such operations are part of shadow finance, a term that describes lending outside the banking system. In a separate step to reform the system, the bank regulator said it will let as many as five privately owned lenders start operating this year.

The Cabinet order shows concern at the highest levels of government that shadow banking, estimated by JPMorgan Chase & Co. at 69 percent of China’s 2012 gross domestic product, may threaten the financial system’s stability. Premier Li Keqiang is seeking to reduce the risk of defaults by cutting leverage in the world’s second-largest economy, where growth last year may have slowed to the weakest pace since 1999.

Property Developers

In the new regulations, sent to ministries and local governments last month, the cabinet ordered tighter enforcement of current rules on shadow finance, the people said. The new directives also include a ban on using third parties to evade restrictions on lending directly to certain borrowers, according to the people. The government restricts lending to property developers as part of a campaign to control home prices.

Shadow banking includes activity ranging from trusts to banks’ off-balance-sheet savings vehicles, known as wealth management products, and private lending between individuals. A lack of transparency has made it difficult for the government to control the level of credit in the economy, while increasing the risk of default.

Wealth Management

The rules order banks to set up separate units for their wealth-management businesses, and to create provisions and set aside capital for them, the people said. The regulations also ban banks from using the products, which are funded by customers’ savings, to buy loans from the bank’s balance sheet, according to the people.

The State Council order also bans trusts from pooling deposits from more than one product and investing them in non-tradable assets, while private equity firms are barred from lending to clients, the people said.

China Business News reported on 5 January the country formally issued rules on shadow banking and clarified the definition of the business for the first time. The report cited a person familiar with the matter who wasn’t identified.

Trusts, Guarantees

The China Banking Regulatory Commission warned of risks from wealth management products that violate regulations, as well as reckless trust businesses, financial guarantees and microfinance, the official Xinhua News Agency reported on its microblog.

A Chinese audit of local governments exposed an increased reliance on shadow banking. Local government debt overdue at the end of June was 1.15 trillion yuan, or 10.56 percent of borrowings, according to National Audit Office data.

The industry has prospered by luring savings from people seeking alternatives to bank deposits whose interest rates are capped by the central bank. Entrepreneurs have taken loans from shadow financiers to grow their businesses. More than 90 percent of the nation’s 42 million small companies don’t have access to capital, Citic Securities Co. estimated in August.

Private Investment

The CBRC plans to allow a batch of three to five banks entirely funded by private investment this year to operate under a trial as part of the country’s financial reforms, it said in a statement. China’s banking system is dominated by state-owned lenders.

Banks and other financial institutions have offered wealth management products, off-balance-sheet quasi-savings vehicles, to retain depositors who have been moving money out of the banking system for higher returns. The value of such wealth products stood at 9.1 trillion yuan at the end of June, according to the China Banking Regulatory Commission.

In recent years, financial institutions have become increasingly involved in interbank business, taking short-term loans from peers and lending to companies for longer durations to circumvent capital requirements, lending quotas and restrictions in loans to sectors such as real estate and local government financing vehicles.

In other moves to rein in credit, the government last year tightened rules on bond sales by local government financing vehicles and companies in industries with overcapacity, while the central bank has tolerated higher interbank lending rates, leading to spikes in June and December.