Getting a grip on shadow banking (2)

However, shadow banking is not without potential risks and regulators are now paying close attention to it.

Shadow banking offers higher returns based on high leverage ratios and it is less regulated. For example, with off-balance-sheet lending, banks can lend their deposits out with higher interest rates since there will be fewer worries about financial indicators such as the loan-loss provisions required by the central bank.

But the high-risk assets underlying many of these products mean "to some extent, this is fundamentally a Ponzi scheme," as Xiao Gang, chairman of the Bank of China, cautioned in October. "Under certain conditions, the music may stop when investors lose confidence."

If more debts rely on non-transparent, supposedly high-yield and off-balance-sheet investments, there are growing fears that problems in the "shadow banking system" may be transmitted to the formal banking system and China may be facing the type of credit crunch that brought the US economy to its knees in 2008. "In such situations there is a possibility of a liquidity crisis being triggered if the markets were abruptly squeezed," Xiao said.

Specifically in China, there is a mismatch of high-risk products with conservative individual investors. In general, high-yield products are of high risk and designed for wealthy investors who have the funds to accept the risk of default.

However, nowadays in China, as lots of the wealth management products are sold by commercial banks in their branches, it is not just wealthy investors that are buying the products, but also ordinary investors and pensioners, who often use all their savings and who don't have enough financial literacy to realize the high-risk nature of the products.

Besides, as banks have historically been the main players in China's financial market, some investors rely on a bank's reputation when buying a wealth management product and believe that banks are "guaranteeing" their investment, which is not the case. The recent default of a wealth management product for which the seller, Huaxia Bank, took responsibility has just increased their blind confidence that banks will bail them out if things go wrong.