UBS: China's Shadow Banking Sector Is Actually Pretty Small

Investors are worried that defaults in China's shadow banking system could trigger a financial crisis.

Chinese policymakers have also grown increasingly cautious, issuing a new set of guidelines this year, known as Document No. 107 to curb the shadow banking sector.

Shadow banking refers to financing activities that occur off-balance sheet and largely goes unregulated.

But in a new report titled 'Why China Is Not Facing A Lehman Moment', UBS' Tao Wang writes that China's "shadow banking system is much smaller relative to the size of its overall financial system when compared with many developed economies such as the US."

She thinks China's shadow banking system was about 50-70% of GDP at the end of 2013. This compares to a global average of 117%, and 170% for the U.S. at the end of 2012 according to data from the Financial Stability Board.

Here's the chart that shows that China's shadow banking system is small compared to other countries. The Netherlands, UK, Switzerland, and the U.S. have much bigger shadow banking systems than China. and they also account for a larger part of their total credit system.

The growth in shadow banking in these countries was largely attributed to the proliferation of synthetic financial products ahead of the financial crisis.

The large size of the Netherlands' shadow banking sector is because of "the large number of special financial institutions (SFIs)," according to a report from DNB - The Dutch Bank.

While China's shadow banking system is the fastest growing, its size is still manageable. Wang also thinks it's manageable because "lack of leverage and securitization, and mark-to-market mechanism in China's shadow banking system."

"Trust companies, corporate bond issuers and other shadow banking players in China are not highly leveraged. They also have almost no securitization, limiting the impact that any default would have on the entire financial system; and their underlying assets are mostly loans. In the event that a cluster of defaults triggers a mass unwind of shadow credit, assets that Chinese banks may be forced to bring back onto their balance sheets would largely be loan assets, which are simpler and more straight forward to "re-intermediate" than the MBS/ABS/CDO structures that US banks had to deal with."

Moreover, Chinese credit growth has been driven by "domestic, not foreign funding" and benefits from high savings.

"Simply put, a systemic banking crisis is not in sight," Wang writes. "For these reasons, should a credit squeeze take place in China (not our base case scenario), it should not be of Lehman proportions."