What are shadow banks and why are they struggling in China?

• Shadow banks are financial institutions that provide services similar to traditional banks.
• China’s shadow banks focused specifically on the country’s real estate market.
• ZEG has filed for bankruptcy on the grounds that it is unable to pay its debts.

Shadow banks are financial institutions that provide services similar to traditional banks. Those services includes lending, investing, or transferring money. Shadow banks are not regulated by the same rules as traditional banks. These banks often deal with hedge funds, money markets, private equity funds and even some investment banks.

According to the International Monetary Fund (IMF), shadow banks symbolize one of the many failings of the financial system leading up to the global financial crisis in 2008. In fact, as shadow banks are not subject to banking regulation, they are not able to borrow from the central bank, especially for emergencies.

As such, the shadow banking system played a major role in the expansion of housing credit in the run-up to the 2008 financial crisis. Despite this, shadow banking has survived and continues to grow. A report by the Financial Stability Board (FSB) in the US indicated that shadow banks grew 8.9% in 2021.

The shadow banking system—which the FSB calls the nonbank financial intermediary (NBFI) sector’s share of total global financial assets reached 49.2% in 2021. The US is the top holder of shadow banking assets, followed by China.

Shadow banks in China

In China, shadow banks started booming after the 2008 global financial crisis. China’s shadow banks focused specifically on the country’s real estate market, which also happens to contribute to one-fourth of the country’s economy.

The BBC reported that China’s shadow banking industry is valued at around US$3 trillion and provides a financial lifeline to the country’s property sector. However, the once-booming industry has been hit by a severe credit crunch, with some of the biggest firms now on the brink of financial collapse.

One company in particular that has filed for bankruptcy is Zhongzhi Enterprise Group (ZEG). ZEG has filed for bankruptcy on the grounds that it is unable to pay its debts. This follows investigations by Chinese officials into suspected crimes committed by the firm in November 2023.

The BBC reported the struggling group informing investors in a letter in November that its liabilities – up to US$64 billion – had outstripped its assets, now estimated at about US$38 billion. At its peak, ZEG’s asset management arm reportedly handled more than a trillion yuan.

In a statement published on the Chinese social media network WeChat, a Beijing court stated that ZEG’s assets are insufficient to pay off all debts and it clearly lacks the ability to repay in full.

Shadow banking-linked wealth managers in China mainly channel the proceeds of wealth products sold to retail investors to real estate developers and other sectors. While the real estate sector may be huge in China, it has been struggling with developers experiencing defaults in payments since 2021.

Apart from ZEG, the head of Chinese property developer Evergrande’s electric vehicle arm has also been detained by authorities also due to suspicion of crimes. Evergrande has reported more than US$300 billion in liabilities.

Shadow banks are not digital banks

While both shadow banks and digital banks are types of financial institutions that operate outside the traditional banking system, they have some key differences. For example, shadow banks can offer more credit and liquidity to borrowers and investors, but they can also pose potential risks, as they are more vulnerable to market shocks and financial crises.

On the other hand, digital banks are banks that operate fully online, without any physical branches or offices^. Digital banks can be either old banks that have moved to delivering internet services or new banks that have been established online. Digital banks can offer lower fees, higher interest rates, and more convenience to customers, but they may also face challenges such as cybersecurity, customer trust, and regulatory compliance.

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