The loan guarantee structure is inherently flawed and if left unchecked, has crisis potential

In principle, the banks are the best players in China’s financing arena for assessing and managing the risk of lending to a certain firm, and are, thus, the best positioned to lend money to small and medium-sized enterprises (SMEs). But the realities of private sector financing in China show that companies cannot always rely on banks to provide the desperately needed capital. This disparity has birthed the overly large shadow banking industry.

But for enterprises and firms that shun the shadowy lending organs that charge interest rates anywhere up to 60%, and can exact a variety of extralegal means of dealing with a defaulted loan, another option has presented itself.

Loan guarantee companies have taken their business to the next level and are underwriting loans at increasing rates to help the firms secure loans from the bank. Just as with any other insurance system, the risk is ostensibly shifted from the bank to the loan guarantee company whereby the underwriter is taking the responsibility should the firm default on their bank loan.

What makes this a viable business in any market are the fees that the loan guarantee companies charge for their services, and as long as there isn’t a massive number of loan defaults, it’s a profitable operation.

The problem and the danger of an over reliance on these underwriters by the banks, is that these companies are in many cases insuring firms who aren’t credit worthy in order to collect as many fees as possible, and banks are more or less accepting the guarantees with little scrutiny since they’re under political pressure to lend to China’s cash strapped SMEs. So in a way, the bank is turning a blind eye to the fact that the risk has not really been mitigated, only underwritten, because as long as they’re finding a way to make loans, they’re following their political directives.

Aside from the political pressure aspect, this is very similar to what went on at the front end of the recent financial crisis in the US, when banks would grant mortgage loans to households that did not meet the standard credit requirements, then create and sell the mortgage-backed security, thereby passing the toxic assets onto the next investor. In China, the loan guarantee companies are acting much in the same way as the US banks did, underwriting credit to companies that simply don’t qualify for loans.

We know from observing the US that the structure is flawed, and a meltdown is inevitable. It may not be next year, but eventually this system will go bust.

What China has going for it now is that the scale of this business is still relatively small. The significant scenarios of loan default that we read about are fairly isolated, but if all of the policy banks in China start lending with abandon through loan guarantees, then the problem becomes massive. Right now the risk on a national level is low, but it has the potential to become a much more urgent situation.

To solve the problem of credit constraints for SMEs, the credit market, rather than the government, has to be the driving force. If the players in the credit market do not have the incentive to serve SMEs, then they will find ways to get around any top-down policy, just like what banks did by passing the risk of lending to SMEs to loan guarantee companies to fulfill their unwilling ‘requirement’. As a result, a policy that aims to help SMEs may actually bring more damage to the credit system. A better policy should encourage competition among all players including banks, where serving SMEs is in their own interest.

Song Zhongzhi is Assistant Professor of Finance at CKGSB