Wednesday, April 8, 2015

Shadow Banking



China sees first default on bond principal

Hi!

Not too sure if you'll guys have read this news that a Chinese Tech firm defaulted on their bond payment. Personally, i felt that it's good move that Chinese government allows this to happen as compared to the past where the CCP would indirectly stepped in to ensure the payments were paid off. So now to gain investor's trust they can't take their cashflow for granted and simply depend on government's help. In the long run under Xi Jinping's leadership, I am quite certain that companies in China will be more credible and gain more investor's confidence as well.

As for now, the 2 China companies I am invested in is ICBC and Bank of China. ICBC is the largest bank in the world in terms of assets and 3rd in terms of market cap, with Wells Fargo coming in the first place.

I bought these shares early last year and the year before. It was the time where China shares got hit real hard due to the news of Shadow Banking.

Lets look at what does shadow banking means :

Shadow banking
The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks.

Let me explain.

Assuming Mr A wants to borrow money e.g. $X million. He can approach banks with probably an interest rate of 10%. So how does the banks get money to lend Mr A? By consumers' fix deposits, structured deposits and etc.

As for shadow banking, let's say Company Z (Coy Z), provide similar service to a bank, but charges lesser interests rates. When someone borrows money from Coy Z, they securitize the debts and issue in the form of bonds and gives credit rating to it

So why Mr A would choose Company Z compared to proper commercial banks?

For banks, before they lend money out, they will also ensure that Mr. A meets the minimum debt servicing ratio, solvency ratio etc. If he doesn't meet any of these, banks won't lend him money and an alternative would be Coy Z, which are not so stringent with such financial ratios.

Secondly, to attract borrowers, they usually offer interest rates which are lower than what banks offer. So someone who just wants a lower interest at the expense of the banks reputation and regulation will borrow from Coy Z.

For banks, they have safety net, which means they have proper regulation and need to ensure checks and balances, and capital adequacy ratios. Hence the chance of bonds default rate is high.

Hence I don't see a point on how the shadow banking system affects commercial banks. Though the commercial banks did help to market the debt, they only act as a sales-agent, and are not obligated to repay investors. If equity investors know that shadow banking doesnt have an impact to justify the drop in share prices of China banks, it is definitely a good time to buy the big 4 banks in China.

However, over the years as the giant nation awakes (I mean China :)) , with much huge demand to borrow to run business and buy things, the commercial banks at times lack the capacity to meet such demands. Hence an alternative would be to approach the shadow banking system. According to some measurements, shadow banking is accountable for 60% of the loans. So imagine one day if the economy fails, borrowers failed to meet debt obligations, bond holders lost their money. Company with much debt will fail, and employers got laidoff and employees and each family spends lesser and hence affects business and it forms a cycle.

So is shadow banking good?

China's ICBC chairman said that it is actually productive. Read here: http://www.reuters.com/article/2014/06/24/china-economy-shadow-idUSL4N0P52X620140624

I believe in the short run, it provides a temporary stimulus to the economy, to encourage and enlarge the capacity to lend. But if one defaults and affects another firm, and more firms, it can create a chain of destruction. That is why CCP is quite long term focused and against it, and they are not gonna rescue firms who fails to meet debt obligation.

-End

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