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China’s Brokerages Turn Shadow Banks

Investors make trades on computer terminals at a securities exchange in Shanghai, China.
Bloomberg | Getty Images
Investors make trades on computer terminals at a securities exchange in Shanghai, China.

Chinese securities brokerages have emerged as a crucial new link in the country's shadow banking industry, a development that underscores how financial risks are spreading more widely in China.

People familiar with brokerages say they got started in shadow financing around the middle of last year, taking control of funds that banks wanted to remove from their balance sheets.

New industry data confirm this development and reveal a dramatic increase in such activity in the fourth quarter. For 2012 as a whole, shadow financing via brokerages appears to have increased almost 600 per cent.

Western rating agencies have warned that a rapid rise in off-balance-sheet banking activity is a threat to China's financial stability. But Chinese regulators have countered by saying the risks are manageable. With the country's financial system long dominated by state-run banks, they also view shadow lending as a byproduct of their attempts to unleash more market forces in the allocation of capital in China.

(Read More: China's Brokerages Earned Less Than Goldman Last Year)

"In August we were told to start allocating more funds to securities companies because that channel was fully open," said a manager with a midsized bank who has been directly involved in shifting assets off his bank's balance sheet.

The Chinese securities association said last week that brokerages now manage almost Rmb2 trillion ($320 billion) of so-called entrusted funds – funds that banks have transferred to brokerages so they are off their balance sheets – seven times more than at the start of 2012.

Brokerages received Rmb1 trillion of entrusted funds in the fourth quarter alone, according to the industry figures.

Every year or so, China's shadow banking morphs into a slightly different form as new players get involved and new products are launched. Regulators largely permit the experimentation to take place but clamp down when the risks are deemed excessive.

The emergence of brokerages as key conduits of shadow banking in China is a sign of how quickly the country's financial institutions are evolving in response to regulatory changes.

(Read More: China Investment Banks Hunker Down as IPO Rules Tighten)

Conventional bank loans account for a decreasing portion of Chinese financing, from 95 per cent in 2002 to just 58 per cent last year, according to the central bank. Total financing increased almost eightfold during that time.

For the past two years China's shadow financing had centred on co-operation between banks and trust companies, which are loosely regulated fund management vehicles.

Banks had funneled cash to trusts, and the trusts in turn made high-yield loans to companies such as property developers that were barred from borrowing from banks because they were perceived as too risky.

Late last year the Chinese banking regulator grew concerned at the surge in trust lending and forced greater disclosure of such financing arrangements.

(Read More: China's Rebound Powered by 'Risky' Sectors)

"The Chinese Banking Regulatory Commission was becoming more restrictive on bank-trust co-operation and that opened the door to bank-brokerage co-operation," said Howhow Zhang, head of research at Z-Ben Advisors, a Shanghai-based fund consultancy.

Banks have been competing more aggressively for customers by issuing "wealth management products", which effectively function like deposits but offer slightly higher rates. To generate the higher returns, banks must transfer the cash to non-bank entities which are less encumbered by lending restrictions. That is where the brokerages come in.

The brokerages play a passive role in managing the entrusted funds, according to people with knowledge of the matter. Banks give the brokerages strict investment instructions and pay them a tiny fee, as low as one basis point, in return.

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People with knowledge of brokerages say they have used the entrusted funds for two main kinds of investments. First, they have bought undiscounted bills from banks, a move that gives the banks more on-balance-sheet room for lending. Second, they have invested in trust products, serving as an intermediary between banks and trusts.

There are clear risks in this enterprise. The undiscounted bills are backed by accounts receivable from companies, so the brokerages are potentially being used as a backdoor channel to fund companies that cannot collect their own debts. Moreover, the question of who bears the ultimate responsibility for defaults is only complicated by lengthening the chain of financing between banks and trusts to include brokerages.

(Read More: Shadow Banking Facing Tougher Regulations)

The rise of brokerages as shadow banks has been remarkably fast, which is also a worry. Nevertheless, looked at in absolute terms, the entrusted funds at brokerages are still just 1.6 per cent of overall bank assets.

"If you want a more comprehensive capital market in which the market share of banks drops, you have to allow things to happen outside the banking sector," said an analyst who covers brokerages, speaking on the condition of anonymity. "It's something that people should pay attention to. But it's not alarming yet."