Why I became a Chinese shadow banker

In the fall of 2010, as deputy head of China investment banking at UBS AG, I spoke to a group of wealthy investors in Beijing about the outlook for Chinese stocks. A rumpled, 50-something man from Hangzhou named Wang Zhigang pulled me aside afterward and asked for my advice about investing. Until then, he had made his money through curbside lending, not stocks. But, he lamented, his returns had dropped from more than 30 percent a year to a mere 23 percent. He worried about his personal fortune, which he had built up from nothing to almost 3 billion yuan (about $445 million back then).

He hardly needed my advice, I told him. “With your performance, even Ba-Fei-Te should farm out some money for you to manage!” I said, referring to Warren Buffett’s name in Chinese.

Intrigued, I flew to Hangzhou a few days later to find out how Wang had done so well. He drove me to the Haining Leather Market to meet some of his customers. They were merchants of leather shoes, handbags and accessories. Their network was wide and close-knit, and they sold products globally through traditional channels, as well as online.

Twenty years ago, these guys would have looked like small fish to a traditional bank. Even after their businesses had grown exponentially, they couldn’t supply the kind of collateral that banks demanded. Yet these merchants needed money, and they needed it fast. So they turned for help to “shadow” bankers, like Wang.

There has been a lot of talk lately about shadow banking in China. Between curbside lenders, microcredit institutions, pawnshops, trust loans, “wealth management products” from banks and other components, this murky and unregulated financial universe is now worth an estimated $5 trillion, challenging the dominance of the traditional banking sector. Such unrestrained growth naturally worries China’s central bank, which fears that a flood of bad shadow loans could prompt a financial meltdown similar to the U.S. subprime crisis in 2008. A liquidity squeeze in June, when the central bank allowed interbank lending rates to rise to as high as 20 percent before intervening, was widely interpreted as a warning to banks to clean up their shadow portfolios.

China’s shadow bankers are easy to demonize. Like Wang, many are nicotine-stained and seemingly unsophisticated. Their methods are unorthodox, possibly even unsavory. Their loans don’t show up on any balance sheets. They look like a disaster waiting to happen.

I believe these fears are misplaced, and I should know: Eight months after my visit to Hangzhou, I became a shadow banker myself. Since 2011, I have run a microcredit firm in Guangzhou, which provides loans to thousands of small-scale entrepreneurs: florists, restaurateurs, fish farmers, vegetable growers, roadside hawkers.

Although we charge about 24 percent annually for our money, demand remains virtually unlimited. Our customers are too small and too unstable to get traditional bank loans. At the same time, because we keep our loan amounts small ― $20,000 apiece on average ― and because we have close contact with our clients, the business has proved reasonably secure. Our bad debts have not strayed above 5 percent since the firm was founded five years ago.

This month, I visited Wang in Hangzhou again. A few borrowers had defaulted in recent months, he told me, but unlike some of his competitors, he had been “extremely lucky.” He was scrupulous about only lending to clients and businesses he knew well, and years of experience had given him a good eye.

“This is my hard-earned money; I have to be careful,” he told me. “My family was dirt-poor when I was a child. I am just so afraid of becoming poor again.” Wang’s fortune had almost doubled since I had last seen him.

One cannot defend a $5 trillion industry with a couple of examples. Two of Wang’s colleagues had been wiped out in the last year after large borrowers defaulted. Several other informal lenders in Hangzhou had ended up behind bars after disgruntled investors accused them of fraud. In recent weeks, news reports have described mass bankruptcies among small businesses that had borrowed heavily from shadow banks at exorbitant rates.

But neither should one condemn all of shadow banking because of stories like these. Shadow banking is well diversified, and serves a legitimate customer base. By and large, it has much lower leverage than banks or corporate China. Losses at shadow banks are often absorbed by entrepreneurs themselves, without affecting the taxpayer.

Even the “wealth management products” offered by regular banks are not to be feared, because they are just deposits, pure and simple, whatever the theoretical distinctions. I buy them myself.

Certainly, the sector could stand to be brought under greater supervision. But many of the regulations already in place are vague and unreasonable. Authorities have never clearly defined something as fundamental as what constitutes “illegal fundraising.” Microcredit operations, like ours, are allowed to borrow from no more than two banks for any more than 50 percent of their equity capital. Why only two banks? Why only 50 percent? These restrictions are arbitrary, and they severely limit our ability to lend to underprivileged customers.

The government and the media are scapegoating the wrong culprit. Shadow banking has flourished in China for one simple reason: financial repression. By keeping interest rates artificially low, authorities have forced savers to search for more lucrative financial products. By favoring banks ― which, in turn, favor state-owned or well-connected private-sector companies with loans ― they have forced small enterprises to seek out people like me and Wang.

Meanwhile, projects that might look sketchy at 9 percent interest rates suddenly look feasible at 6 percent. Under such conditions, traditional banks have steadily lowered their lending standards ― from prime loans to subprime and then to simply silly loans.

Sound familiar? That’s how the 2008 financial crisis began, too. Leaders are right to worry about the possibility of a banking crisis in China. But instead of focusing their ire on shadow bankers, they should raise benchmark interest rates in order to reduce the amount of credit flowing to dodgy loans through the formal banking sector. The threat to China’s financial system is right there ― out in the open ― not lurking in the shadows. 

By Joe Zhang

Joe Zhang is the author of “Inside China’s Shadow Banking: The Next Subprime Crisis?” ― Ed.

(Bloomberg)