If you want a barometer to measure financial power sentiment, you can do worse than look at one of the most prosaic financing mechanisms for the world economy: a centuries-old trade finance product called a banker’s acceptance.
Similar to other devices used to lubricate the wheels of commerce – supply chain financing, factorization, invoice financing, debentures – banker acceptances are designed to be just as safe as dull. They are guaranteed, short-term payment promises that are guaranteed by a bank and delivered liquid by being traded on an exchange. A stable, predictable market should be a given.
But as Lex Greensill showed, even an everyday financial product can be turbo-charged to something that has little resemblance to the original concept, hides off-balance sheet risk and causes billions of dollars in losses for inattentive investors. Ask for Credit Suisse now entangled in a web of legal claims from clients who have invested funds in Greensill’s “innovative” supply chain financing approach.
For years, China’s banks and the broader Chinese financial sector have been innovating in a not different way with banker’s acceptance. According to CEIC data, China’s banker acceptance market was worth Rmb3tn at the end of last year, down from a peak close to Rmb8tn in 2014, but still large and a key part of the shadow banking activity that China relied on to boost its growth.
Shadow banking as part of China’s overall financial activity has grown dramatically over the past year. It now accounts for more than 60 percent of GDP, compared to almost nothing before the global financial crisis, according to research published by Manchester School and Wiley. This puts it ahead of the UK, where shadow banking services have also grown in importance but are equivalent to barely half of GDP.
Shadow bank products are many and varied, but most of them somehow short-circuit mainstream bank regulation. The acceptance of bankers has become an important way for Chinese banks to comply with government thickness on loans as it counts as loans while avoiding the capital levy of balance sheet loans.
A number of issues raise potential concerns. Banker’s assumptions can be used as the archetypal alchemical off-balance sheet cash generator: a bank receives cash via a collateral installment from a customer in exchange for an off-balance-sheet guarantee; it is then able to trade the banker’s acceptance with another bank that may be even more eager to increase loan volumes without inflating its balance sheets.
The appeal for banks is clear. But alchemy also works for customers. Matthew Lowenstein, an analyst at J Capital Research, wrote several years ago about evidence of collusion between regional banks and local governments that essentially used the products to print their own money. Today, local governments are under stress again, as their lucrative practice of raising public funding by selling land to real estate developers has been curtailed by Beijing. Suddenly, there is a renewed incentive for creative money printing.
Important security devices of the original banker’s acceptance formula were also set aside. Standard short-term periods of a few months are regularly transferred by banks that do not want to end the party. Collateral levels have been lowered. Inadequate control over the validity of security and underlying trading transactions may also have facilitated fraud.
A fight against fraud was launched in 2017, one of the reasons for the sharp drop that year in the issuance of account financing, such as bank acceptances and trading paper. The problem was far more pervasive than some fictitious trading transactions. A large part of the loan proceeds were then used to buy property, local experts say. Wealth management products, another shadow bank activity driven by banks, have also been recycled in banker acceptances.
A second shock followed in 2019 Baoshang Bank fail. The interbank finance market was seized, in part due to concerns about fraud and inadequate collateral on bankers’ acceptances.
No matter how safe these types of products are in theory, they are certainly not risk free in practice. Unfortunately, the market is increasingly praising them as if they were. In China at the end of last month, demand for banker acceptances hit a new highlight, while banks have been striving to achieve government lending targets. The resulting return: a reasonable “risk-free” 0.007 percent.