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Thursday, March 28, 2024

China Is Cracking Down On Shadow Banking, But One European Country Is Encouraging It

Courtesy of ZeroHedge. View original post here.

When you hear about Shadow Banking, most people still associate it with dodgy Chinese schemes where more and more financial transactions were conducted outside of the normal and regulated banking system. In a previous column, we already briefly discussed how the Chinese shadow banking system had an impact on the copper price.

The scheme was actually pretty simple, and was aimed at maximizing the potential profits on borrowed money as even though copper importers in China received letters of credit valid for 3-6 months, the purchased copper was immediately sold on the domestic market, meaning the importer basically had a ‘free’ line of credit as it could invest the proceeds from the copper sales before having to repay the money drawn down from the letter of credit.

China has been trying to reduce the size of the shadow banking sector, and we argued this was one of the main reasons for the copper price weakness. As the world economy is correlated with how China is doing, the world is obviously keeping a close eye on the Chinese policies, and several first world countries blamed the Chinese regulators for letting things escalate.

But the truth is, the shadow banking issue is much more wide-spread than just China. Sure, the Chinese situation escalated pretty quickly, so it attracted more (unwanted) attention, but let’s have a look at how the shadow banking system is working elsewhere in the world. There is very little doubt peer to peer lending, which is essentially the basis of any shadow banking system, is booming and crowdfunding websites and simple P2P websites are popping up everywhere.

Source: ECB

According to a recent working paper of the European Central Bank,  the total assets of the shadow banking systems in both the Eurozone and the USA are increasing. Unfortunately the most recent data are limited to the end of 2014, but in the 12 years leading to 2014, the total assets of the shadow banking ‘system’ increased by no less than 30 trillion Dollar! Interestingly, the ECB research indicates the shadow banking grows faster during a period of economic stability. On the one hand this definitely makes sense, as lenders will be willing to take more risk, but on the other hand one could argue the shadow banking system proves its value when the commercial banks are ‘closed for business’, and peer to peer lending could be seen as some sort of measure of last resort.

What’s even more interesting is the fact the same working paper describes the shadow banking system as having a ‘potential destabilizing impact on the financial sector as a whole’ because ‘the shadow banking system grows to a size where purchases by traditional banks are insufficient to prevent a fire-sale in the case of its liquidation’ (quoted verbatim from the paper).

Indeed, plenty of reasons to be(come) very worried here, and you’d think the national regulators and supervising bodies would be keen to try to ‘fix’ this issue by making stricter rules. Surprisingly, China is actually the frontrunner here as the country has recently imposed limits on peer to peer lending platforms. Private borrowers are now maxed out at 1 million Yuan, with a limit of 200,000 Yuan per lending platform. That’s a first step to try to ease the market again after one of the country’s internet-based lenders defrauded almost 1 million ‘clients’, with a total loss of almost $8B.

This probably won’t be the only major default, as according to the China Banking Regulatory Commission, 1,778 of the 2,349 online lenders could be described as problematic, so something will have to be done.

You’d think the Western world would keep a very close eye on the developments in China, and the problems created by the shadow banking system there. You would also think the western countries would put a limit on peer to peer lending as well, but that couldn’t be further away from the truth. In the United Kingdom, for instance, is the relative size of the shadow banking industry continuously increasing, taking up to 30% of the total financial assets in the country.

Source: Bank of England

Not only is this quite an alarming level, you’d also think the UK would try to put a cap on peer to peer lending, but that couldn’t be further from the truth. In reality, the government is now actually starting to support peer to peer lending by allowing it to be used on a tax-free basis in the so-called ISA’s (Individual Savings Account), where P2P lenders are ‘guaranteeing’ certain returns on peer to peer lending.

Source: Bank of England

The shadow banking problem might be more wide-spread than originally anticipated, and it’s shocking to see how some western governments are even encouraging peer to peer lending by making the proceeds and interest income tax free. And this could potentially prove to be a bigger risk than the systemic risk of the banking sector. After all, in peer to peer lending schemes, there usually is no collateral, and even if there is, it will be more difficult to collect and monetize the collateral, making investors worse off.

Shadow Banking could harm your wealth. Read our Guide to Gold and protect yourself!

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