China's campaign to cut high debt levels in its economy is aiming this year to shrink the $3 trillion shadow banking sector, which could drain a critical source of income for the country's banks and of funding for its fragile bond market.
Shadow banking, a term for financial agents that perform bank-like activity but are not regulated as banks, has boomed in China, the world's second-largest economy, as a way of circumventing government's tight controls on lending.
It has been a key driver of the breakneck growth in debt in the economy, which UBS says rose to 277 percent of GDP from 254 percent in 2016, and is now a target as Beijing tries to reduce that figure before it destabilizes the economy.
But with banks' shadow banking business accounting for about a fifth of total outstanding loans, analysts fear that the unintended consequences of government efforts could trigger the fate it seeks to avoid.
"We see a policy-induced drastic deleveraging in shadow banking as a policy miscalculation that could trigger unexpected tail risks for the banking sector," said Liao Qiang, credit analyst at S&P Global Ratings.
Investors' concerns stem from new rules this month that put lenders' wealth management products (WMPs), the biggest component of shadow banking, under the scrutiny of the People's Bank of China (PBOC) for the first time and into its calculations on prudence, capital adequacy and loan growth guidelines.
According to the latest official data, WMPs jumped 42 percent year-on-year to 26 trillion yuan ($3.8 trillion) at the end of June, doubling in just two years.
WMPs are typically kept off banks' balance sheets, making it difficult for regulators to assess the stability of a banking sector reliant upon them for growth.
And just as in the global financial crisis of 2008, banks' interconnectedness amplifies the risks. Banks are increasingly buying into each other's WMPs, such that interbank WMPs hit 4 trillion yuan in June, a doubling from two years ago.
Banking regulators are also seeking new rules that will require lenders to set aside adequate capital to absorb potential losses from WMPs.
The PBOC and China Banking Regulatory Commission have yet to respond to requests for comment.