Thursday, April 12, 2012

Shadow Banking and Its Pound of Flesh

Shadow Banking on Trial

"Rich Sister" Wu Ying weeps during sentencing for defrauding investors

The most shocking thing about the attached article on China’s “Rich Sister” is not so much her methods of having “illegally” raised money or her being accused of subsequently defrauding her investors, but rather, the pending punishment she is facing – execution. Borrowing or raising investment funds through informal, non-official “shadow banking” channels is an all-too-common occurrence in rapidly developing countries with tightly controlled banking systems. Not paying investors back - either because someone can’t or won’t – is, sadly, a misfortune as old as money itself. And showing off wealth obstentatiously through owning multiple homes, cars (including a $500,000 Ferrari) and alluringly placed tattoos is, well, almost a badge of honor in materialistic modern China. On the other hand, putting someone to death for committing a combination of the first two misdeeds (maybe compounded by the third) reflects much worse on the legal system than the culprit. Especially when the legal system belongs to the world’s latest superpower.

Shadow banking systems, wherein money is collected informally from individuals and lent to other small borrowers, arise when the official banking system does not meet the credit needs of small businesses or individuals. Often, as is the case in China today and was the case in Japan and Korea when they were developing at a similar pace 2-3 decades ago, the major banks focus on lending money to large, state-owned or –affiliated borrowers, to the detriment of smaller beneficiaries. This policy of lending big occurs in developing countries for a combination of reasons:

- Banks are directed by government policy to build up strategic industries;
- Banks get a bigger bang-for-the-buck in terms of assets, interest income and fees by lending to large corporate entities;
- Powerful people behind the large corporates are able to exert influence on banks;
- Developing banks lack the credit know-how to lend to small businesses and individuals and manage relationships with the borrowers.

China’s shadow banking is estimated to be between US $1.5 - $2.5 trillion – a staggering size that evidences just how vital this system has become in driving domestic investment. Similarly, in Korea during the height of the “curb”, or “gae”, market during the mid-1990s, informal loans represented 30-40% of total bank assets. In Korea and Japan, much of the market was administered by organized crime organizations. So failure to repay was dealt with harshly. However, the punishment was doled out outside of the official legal system, not as part of it.

“Rich Sister” is not the first person in China to be facing execution because of financial crimes. China has a history of regularly convicting and sentencing guilty persons to death. Interestingly, a high proportion of them are women, reflecting an unfortunate consequence when the ambitious nature of Chinese women collides with the fewer opportunities they have to borrow money through official channels. However, the case of “Rich Sister” has received the most media attention, by far. Rapidly-rising public frustration with domestic economic policies that are seen to unfairly favor the rich and privileged are a key factor.

The hopeful news is that the rattling of public discontent has not fallen on deaf ears. Officials as high as Wen Jiabao, China’s premier, have recently called for major reforms in the banking system, including break-up of the “monopoly” large banks and more systemic focus on promoting small entrepreneurs. This will take time, and reform and restructuring of China’s financial systems will be fraught with moral and ethical peril that will play out with dangerous consequences over the coming years. However, painful reform is surely a necessarily evil to address legal processes that belong more in the time of Shylock and medieval Venice than in the 21st century.

Details Here