A massive threat to China's banks is building, and it looks a lot like a Ponzi scheme

Fitch Ratings has released a warning on a threat building inside the $34 trillion Chinese banking system.

Wealth management products (WMPs) have exploded in popularity over the past few years.

We’ve heard about these products blowing up investors’ faces in China before, but the way Fitch makes it sound now, the situation has become even more dire.

In fact it sounds like a Ponzi scheme, as banks issue new WMPs to pay for old ones:

Fitch believes that the most common source of WMP repayment is through the issuance of new products, resulting in persistent rollover/payout pressure on banks. WMP issuance during 2015 topped CNY158trn – from CNY114trn in 2014 – highlighting the high churn rates of these products. When banks are unable to roll over, they have to either draw on their on-balance sheet liquidity or borrow money from the interbank market to meet payouts.

As hedge fund manager Kyle Bass pointed out in a letter last month, WMPs are structured so that they don’t count toward Chinese bank lending deposit restrictions. That means banks can use them to generate income, but they don’t show up as on balance sheets.

“WMPs, TBRs [Trust Beneficiary Rights], and the 8,000+ credit guaranty companies constitute the majority of China’s shadow banking system,” Bass said in his letter. “This system has grown 600% in the last 3 years alone. This is where the first credit problems are emerging, away from the eyes of regulators.”

At the end of 2015 WMPs made up
16.8% of system deposits. That’s 23.5 trillion yuan, up from 15 trillion yuan in 2014, according to Fitch.

Standard & Poor’s talked about WMPs in February and said “a growing reliance on WMPs to manage regulatory capital ratios could undermine the bank’s true capitalisation.”

Fitch referred to them as a “hidden second balance sheet, but with poor disclosure and few reserves or capital to cushion losses.”

In other words, while they generate income, WMPs are a ticking time bomb. Fitch says that China’s mid-tier banks are most at risk, with 42% of the market share of WMPs. State banks aren’t far behind, though, with 36.9%.

What’s more, there is a way that WMP risk can spread into China’s capital markets, which have had a habit of leading global capital markets into a tailspin.

From Fitch:

Banks have also been increasingly investing in WMPs on their own books in recent years, and capital invested in WMPs has been channeled into equity markets and forms of mezzanine financing in addition to traditional fixed-return asset classes such as corporate bonds. This could add to the aforementioned credit and liquidity risks by raising bank exposure to capital market volatility.

So if you were looking for something to worry about, here you go.

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