China’s Internet-only lending platforms could pose risks to the larger banking system: legal scholar

23rd September 2016. By Tsering Namgyal

China is probably one country in Asia where shadow banking activities might have crossed the threshold of so-called systemic relevance, according to a leading specialist in shadow banking.

Christian Hoffman, a professor of financial law at the National University of Singapore and a former legal counsel to the Deutsche Bundesbank, said regulators in China need to step up the rules governing shadow banking, given the growing risks such credit intermediation could pose to the larger banking system.

“China is one example in Asia where the peer-to-peer lending is an area of concern not just from an investor protection point of view, but from the risks that it could potentially pose to the entire banking system,” he said at a talk in Hong Kong.

The indications that traditional banks themselves are lending money through online-based mechanisms means the issue of crowd funding and peer-to-peer, or P2P, lending has become greatly inter-connected with the larger banking system, he said.

Unlike other jurisdictions in Asia, the scale of such activities in China has reached a level that could mean a spillover effect on the banking system as well as to the economy in general, if things were to go wrong, Hoffman said.

In general, one way such risks from shadow banking — also known as “other financial institutions,” or OFIs — could materialize is through large-scale redemptions that could lead to a fire sale of assets, said Hoffman, who served as a legal counsel for the Bundesbank during the global financial crisis.

His statements came in response to media reports about the growing size of losses in China’s shadow banking system.

The stricter post-crisis regulations governing banks, primarily in terms of higher risk-based capital ratios under the Basel III framework, have played into the hands of less-regulated peers in the so-called non-banking sector. As banks have become less reluctant than in the past in extending credit, especially to higher risk customers, it has created a fertile ground for such non-bank finance companies to take root.

This, combined with the high penetration of Internet and mobile-based platforms, has helped expand the reach of shadow banking by allowing an easy conduit for retail investors to turn cash into investment schemes guaranteeing high returns.

It is therefore understandable, Hoffman said, that most regulators are currently concerned about approaching online-based lending platforms from the point of view of protecting the unsophisticated investors who are lining up to lend to high-risk customers.

In terms of definition, shadow banking includes open-ended fund companies, hedge funds, as well as crowd-funding and P2P lending activities, but does not include pension funds and insurance companies.

In addition to adequate and strict regulations governing pension funds and insurance firms, the risk of large-scale redemptions and liquidity crunches are rare, Hoffman said.

He said he believes it is time for regulators to step up the rules governing shadow banking, especially over those firms that may not be “banks” or deposit-taking institutions in the traditional sense of the term, but are acting more or less like banks.

On the whole, he argued for casting a wide net over a range of shadow banking activities so that they do not escape the regulator’s view.

Such measures could include safety mechanisms for investors and liquidity safeguards in the event of large-scale redemptions or withdrawals, he said. Unlike banks, they could not fall upon deposit guarantee schemes, for instance.

In this regard, among all the activities, money market funds come closest in the way they mimic traditional banking, he said.

China is unique in that sense, he said, as shadow banking activities in Hong Kong and Singapore, while growing rapidly, are relatively small in size and not yet systemically significant. The issue of money market funds, which is posing a major challenge for regulators in Europe and the US, is not as pronounced in the two Asian financial centers, he said.

Earlier this month, the Financial Stability Board, or FSB, in a comprehensive report on the implementation of global financial regulations, pointed to shadow banking as one of the fault lines that could threaten the stability of the global banking system. It urged G-20 leaders to take prompt action to address those risks.

Some Asian bankers have also been increasingly calling for a more level playing field, suggesting that online-based finance companies are slowly chipping away at their traditional banking business, without having to comply with the entire kitchen sink of bank regulations, MLex reported.

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