Financial crisis - Essay Example

Teacher Shadow banking in China Shadow banking in China is a financial system whereby non-bank financial intermediaries provide traditional financial services and banking functions to traditional commercial banks. In simpler terms, it meant that intermediaries called trust companies which are not allowed traditional banking functions such as receiving deposits and loan out money, can manage the money from commercial banks. The common transaction involving shadow banking are WMP or wealth management products which are really just savings deposits with higher annual return of a guaranteed 3%.

Compared to the traditional savings deposit, this 3% is way higher which explains why a lot of depositors and investors put their money in WMPs. The reason why WMPs have higher interest yields is because they are tied up with riskier bank loans of intermediaries. WMPs are also not held in bank’s balance sheets which means that that there are no capital set aside for them during defaults. Shadow banking creates a vicious cycle because intermediaries or trust companies also loans out to a companies which in turn can also deposit back to a bank which will again transfer it to an intermediary.

Such money will again be recycled except that a certain portion of it held through the mechanism of RRR or reserve requirement ration (which is really just liquidity ratio) which is portion of the loan that must be withheld from loaning out. This cycle is vicious because a $10 deposit can be loaned for $8 to another company which can again deposit it to a bank which will again loan it out for $6.4 where the same amount diminishes in the cycle. In the process, the investor is guaranteed a 3% return for the deposit.

This kind of banking is not sustainable in the long run. Shadow banking in China is US equivalent of credit swap which is tied up to riskier loan. In China’s shadow banking, WMP’s are tied up intermediaries riskier loans which are not registered in company’s balance sheets and therefore not backed up by capital in case of default. In the US, credit swaps are credits lumped together with riskier loans such as subprime mortgage and then sold to another entity. The principle are the same except that US credit swap is riskier to China’s shadow banking which only guarantees a 3% return on WMPs credit swap contains subprime loans that are almost certain to default.

This shows that both system is not sustainable in the long run because of the risk involved and the investments not guaranteed by capital for potential default.