License to kill: why a 0.007% return could be dangerous

If you want a barometer to gauge the mindset of the financial sector, you could do worse than look at one of the most mundane financing mechanisms in the global economy: a centuries-old trade finance product. called banker’s acceptance.

Similar to other devices used to grease the wheels of commerce – supply chain finance, factoring, invoice finance, letters of credit – bankers’ acceptances are designed to be as secure as they are dull. They are collateralized and short-term promises of payment guaranteed by a bank and made liquid by being tradable on the stock exchange. A stable and predictable market should be taken for granted.

But as Lex Greensill has shown, even a mundane financial product can be turned into something that bears little resemblance to the original concept, masks off-balance sheet risk, and causes billions of dollars in losses for investors who ignore it. Just ask Credit Suisse, now embroiled in a network of legal claims from clients who had invested funds in Greensill’s “innovative” stance in supply chain finance.

For years, Chinese banks and the Chinese financial sector as a whole have innovated in quite similar ways with bank acceptances. According to CEIC Data, China’s bankers’ acceptances market was worth Rmb3tn at the end of last year, up from a peak of nearly Rmb8tn in 2014, but still large and a key part of the shadow banking business that China is focusing on. is supported to fuel its growth.

Shadow banking as a proportion of China’s overall financial activity has increased dramatically in recent years. It now represents more than 60% of GDP, against almost nothing before the global financial crisis, according to a study published by Manchester School and Wiley. This puts it ahead of the UK, where shadow banking has also grown in importance, but is barely half of GDP.

Alternative banking products are many and varied, but most of them somehow bypass traditional banking regulation. Bankers’ acceptances have become an important way for Chinese banks to comply with government lending dictates, as they count as loans, while avoiding the capital charge of balance sheet loans.

There are a number of issues that pose potential problems. Bankers’ acceptances can be used as the archetypal alchemical off-balance sheet cash generator: a bank receives cash via a down payment from a customer in exchange for an off-balance sheet collateral; he is then able to exchange the banker’s acceptance with another bank which might be even more eager to increase loan volumes without inflating its balance sheets.

The attraction for banks is clear. But chemistry also works for customers. Matthew Lowenstein, analyst at J Capital Research, wrote several years ago about evidence of collusion between regional banks and cash-strapped local governments who used the proceeds primarily to “print their own money.” Today, local governments are under pressure again, as their lucrative practice of raising public funds by selling land to real estate developers has been limited by Beijing. Suddenly there is a renewed incentive for creative money printing.

Important safety features of the original banker’s acceptance formula were also bypassed. Short-term standard terms of a few months have been regularly extended by banks reluctant to end the party. Guarantee levels have been lowered. Insufficient checks on the validity of securities and the underlying business transactions may also have facilitated fraud.

A crackdown on fraud was launched in 2017, one of the reasons for the sharp decline that year in bill financing issues, such as bankers’ acceptances and commercial paper. The problem was much more widespread than a few fictitious trade agreements. Much of the loan proceeds were then used to purchase real estate, according to local experts. Wealth management products, another shadow banking activity pushed by banks, have also been recycled into bankers’ acceptances.

A second fear followed in 2019 after the bankruptcy of Baoshang Bank. The interbank finance market has crippled, in part because of concerns about fraud and insufficient collateral on bankers’ acceptances.

No matter how safe these types of products are in theory, they are certainly not without risk in practice. Unfortunately, the market is valuing them more and more as if they were. In China, at the end of last month, demand for bankers’ acceptances hit a new high as banks strived to meet government lending targets. The resulting return: 0.007% roughly “risk free”.

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