The emergence of so-called shadow banks, or financial organizations able to operate without close government oversight, was one of the key developments that set the stage for the 2008 financial crisis that rocked the world. Now, after years of stimulus and economic expansion, shadow banks in China may pose a threat. The national government is now responding with efforts to bring the sector under government regulation.

China

China’s local debt surge

A recently released report that showed that local debt in China has surged to nearly $3 trillion dollars set off alarms around the world. While most do not believe that China’s debt levels represent an immediate problem, financial experts agree that China must curb its appetite for debt, or risk finding itself overburdened.

Shadow banks work by providing loans and conducting other financial transactions outside of the normal bounds of regulators. This allows them to skirt oversight. In many cases, these shadow banks are engaged in highly risky and highly speculative transactions.

China’s government to regulate shadow banks

China’s cabinet has distributed rules to financial regulators that will target the rapid growth of loans being made outside of formal and regulated channels. The plan, which was drawn up in December, has yet to be publicly released; however, it is believed that the central bank and other regulators will be granted increased oversight so they can get a handle on the debt problem.

Total debt levels for China have risen about 200%. This debt includes both public and private debt. To put that into perspective, the United States saw its debt levels build up to just over 200% in the years running up to the 2008 financial crisis. Japan also saw its total debt levels surge to nearly 200% in the run up to its 1990 financial crisis. China’s debt is now actually higher than it was for both the United States and Japan during their respective crises.

China’s shadow banking industry is led by banks with off-the-sheets lending units, insurance companies, trust companies, pawn brokers, and other organizations out of the view of regulators. These organizations may be introducing massive amounts of risk to a economy already at risk of slowing down. If the economy does slow down, companies and individuals may have trouble making good on their debt, which in turn could cause them to default and thus set off an economic crisis.

The government’s move to bring shadow banking under control comes at a time when the government is trying to liberalize its economy, which is currently dominated by state-owned firms. Privatization could increase the risk of bubbles forming as private companies under less oversight grow in size and number. With China’s economy slowing and liberalizing at the same time, the risk of a financial bubble building will only mount. This logic, however, seems to be spurring the government into action.