Finance

Licence to kill: why a 0.007% yield could be dangerous

If you want a gauge to gauge the storm in financial sector sentiment, you could do worse than look at one of the world’s most popular financing mechanisms: a centuries-old trade finance product called banker acceptance.

Compared to the other devices used to lubricate the wheels of commerce — supply chain finance, factoring, invoice financing, letters of credit — bank admissions are designed to be as safe as they are tedious. They are guaranteed short-term payment promises that are secured by the bank and turn them into liquid by being tradable on the stock exchange. A stable and predictable market should be taken for granted.

But as Lex Greensill has shown, even an ordinary financial product can turn out to be something that doesn’t look much like the original concept, hiding off-balance sheet risks and causing billions of dollars in losses to investors who aren’t paying attention. Just ask Credit Suisse, now embroiled in a web of legal claims from customers who have money invested in Greensill’s “innovative” supply chain finance initiative.

For years, Chinese banks and the broader Chinese financial sector have been innovating in a way not unlike bank acceptance. According to CEIC data, China’s bank admission market was worth 3 trillion renminbi late last year, down from a near peak of 8 trillion renminbi in 2014, but it is still broad and a major part of the shadow banking activity that China depends on to fuel its growth.

Shadow banking as a proportion of China’s overall financial activity has grown significantly in recent years. It now accounts for more than 60 percent of GDP, compared to nearly none before the global financial crisis, according to research published by the Manchester and Wiley School. This puts it well ahead of the UK, where shadow banking has also grown in importance, but is barely equal to half of GDP.

Shadow banking products are many and varied, but the bulk of them are somehow abbreviated prevailing banking regulations. Bank approvals have become an important way for Chinese banks to comply with government dictates on lending, as they are considered loans, while avoiding capital charges for balance sheet lending.

There are a number of issues of potential concern. Bank approvals can be used as a typical off-balance sheet chemical cash generator: the bank receives cash via an advance payment from the customer in exchange for an off-balance sheet guarantee; He is then able to trade the banker’s acceptance with another bank that may be more eager to increase the volume of loans without inflating its balance sheets.

The attractiveness of banks is obvious. But alchemy works with clients, too. Matthew Lowenstein, an analyst at J Capital Research, wrote several years ago about evidence of collusion between regional banks and cash-strapped local governments that used the products primarily to “print their own money.” Today, local governments are under pressure again, as their lucrative practice of increasing public financing by selling land to property developers has been restricted by Beijing. Suddenly there was a renewed incentive to print money creatively.

The important security devices of the original banker’s acceptance format have also been bypassed. Standard short-term durations of a few months were routinely rolled over by banks that didn’t want to end the party. Warranty levels have been reduced. Inadequate security validations and basic business transactions may also have facilitated fraud.

A fraud crackdown was launched in 2017, which is one of the reasons for that year’s sharp decline in bill financing issuance, such as bank and commercial paper acceptance. The problem was much more prevalent than a few bogus trade deals. Local experts say that a large part of the loan proceeds were later used to purchase real estate. Wealth management products, another shadow banking activity that banks pay, have also been recycled into bank endorsements.

A second panic followed in 2019 after the failure of Baoshang Bank. The interbank financing market has stalled, in part due to concerns about fraud and inadequate collateral over bank acceptance.

No matter how safe these types of products are in theory, they are certainly not risk-free in practice. Unfortunately, the market is increasingly pricing it as if it were. In China at the end of last month, demand for bank acceptance reached a new high, as banks sought to hit government lending targets. Yield: Substantially “risk free” 0.007%.

patrick.jenkins@ft.com

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