Shadow banking in China slows, contributing to financial risk reduction

But there are new challenges ahead.

Moody's Investors Service says that the pace of shadow banking activity in China has nearly converged to the rate of nominal GDP growth in recent quarters, as overall credit flows shift back toward the formal banking system.

According to a release from Moody's Investors Service, these trends reflect ongoing measures to contain financial risks, offset by monetary policy easing to support bank lending.

According to Moody's latest estimates, China's shadow banking assets reached RMB41 trillion at end-2014, representing 65% of GDP, compared to 58% at end-2013. But a slowdown is clearly evident, as seen in the shrinking share of shadow banking in overall credit flows.

Moody's analysis is contained in its third edition of the Quarterly China Shadow Banking Monitor. The Monitor draws on publicly available data sources to provide an overview of trends and developments in this important component of the Chinese financial system.

Here's more from Moody's Investors Service:

"The shift in credit flows back to the regulated banking system should enhance transparency and reduce financial risks, but it could also create pressure on some borrowers, such as small and medium-size enterprises and small property developers who are reliant on the shadow banking sector," says Michael Taylor, Moody's Chief Credit Officer for Asia-Pacific.

Moody's also highlights changes taking place in the composition of shadow bank lending due to tighter regulations and surging investor interest in the stock market.

"The share of trust sector assets in the capital market has increased at the expense of more traditional trust loans, and activity of leasing companies is growing rapidly" says Stephen Schwartz, Moody's Senior Vice President and a co-author of the report.

"Also, despite recent measures to slow the rise in margin finance in the equity market, outstanding margin loans have continued to rise."

More generally, the high degree of interconnectedness between the shadow and formal banking systems in China poses financial risks.

Linkages arise from banks' distribution of wealth management products, bank lending to trust and securities companies, and spillover risks from financial leasing and guarantees. Other risks highlighted in the report include maturity mismatches and elevated property sector exposures.