In 2007, Paul McCulley, then a managing director at PIMCO, a large U.S. investment firm, coined the term “shadow banking” in a speech at the famed annual U.S. Federal Reserve summer symposium in Jackson Hole, Wyo. He defined shadow banking as the “whole alphabet soup of levered-up non-bank investment conduits, vehicles and structures.” In other words, financial institutions and products that fell mainly outside normal regulatory supervision by central bankers and other government authorities.
McCulley’s introduction of the term was timely since a year later the U.S. shadow banking system ― such as the hidden and opaque trading of derivatives ― was largely blamed for triggering the global financial crisis. Potential problems still persist since it is estimated that shadow banking now accounts for up to half of the global financial sector.
But shadow banking is nothing new for Korea. It and the rest of Asia had already been grappling with the concept of shadow banking and its dire consequences for years. And it once again looks set to be the most important financial regulatory issue facing the region.
The disastrous results of shadow banking were first evident in the growth of “zaitech,” or financial engineering, in Japan that led to the stock market and property bubbles that burst at the beginning of the 1990s, plunging the country into two decades of economic stagnation.
In the case of Korea, the shadow banking system referred to an extensive network of non-bank financial institutions that helped fuel excessive and unsustainable corporate debt levels that resulted in the financial crisis of 1997. Because of tight government restrictions on commercial bank lending, institutions such as finance companies and merchant banks had been established to offer an alternative source of lending to companies.
They were created with the encouragement of the government, which viewed them as a way to attract money from the large underground economy because they offered higher deposit rates than commercial banks. They also charged above market rates on loans. Few restrictions were placed on their management of asset portfolios and their capital requirements were less strict than regular banks. The mushrooming growth of these financial institutions, which also included mutual savings banks and investment trust companies, led to an orgy of borrowing and lending with little oversight and created the huge Korean corporate debt bomb that exploded in 1997.
There are growing worries now that something similar is happening on a vastly larger scale in China, with much talk that the Chinese shadow banking system could become a new source of global financial instability.
The complex Chinese financial industry has many parallels to that of Korea of the 1990s, with an over-regulated commercial banking sector reluctant to lend to non-state companies, with the resulting heavy reliance by the private business sector on funding from the shadow banking system. Cash-starved private Chinese companies are being forced to pay high interest rates on loans and would be unable to service their debts if there is an economic slowdown. This would trigger a collapse of many non-banking financial institutions, as happened in Korea in 1997, resulting in a major financial crisis in China that could endanger the already painfully slow global economic recovery.
The scale of the problem is enormous since the size of China’s shadow banking system is estimated at $2.4 trillion, almost equal to the U.S. consumer debt. There is a risk that financial contagion could spread to Asia’s main banking centers in Hong Kong and Singapore and it would have a significant impact on the Korean economy since China is the country’s single largest trading partner.
Another source of concern is whether shadow banking practices common to the West will be adopted in Asia. These practices are being imported by Western banks as they shift more of their operations to Hong Kong and Singapore to avoid tougher regulatory requirements in the United States and Europe in the aftermath of the global financial crisis.
In contrast to the anti-banking sentiment in the West, Asia is still regarded as “banker-friendly” and is seen as the future growth area for the global banking industry. While many Western banks will stick with well-tested and consistent risk standards across Asian markets, others might be tempted to employ unorthodox techniques to build a regional presence quickly. This could take the form, for example, of setting up complex legal entity structures to take advantage of regulatory inconsistencies across jurisdictions.
These issues pose a number of challenges to Asian financial regulators, including how to deal with regulatory arbitrage in the region. Some of the challenges are national in scope. For example, Chinese authorities need to find ways to channel underground funds into regulated lending institutions, but it will be difficult to do so unless Beijing decides to allow interest rate liberalization.
Korea did a good job in cleaning up its shadow banking system after the 1997 financial crisis. Nearly half of the non-banks were shut down and regulatory supervision of the financial sector was greatly improved. But even now, work continues to reform the shadow banking system, with Korean regulators deciding just last weekend to suspend the operations of four mutual savings banks. And given the connectivity of the international financial system, Korea should be aware that it is also still vulnerable to problems caused by shadow banking elsewhere in Asia.
John Burton, a former Korea correspondent for the Financial Times, is now a Seoul-based independent journalist and media consultant.