Carl Walter, former COO of JP Morgan in China and CEO of its China banking subsidiary, paints a gloomy picture of the Chinese banking system and outlines the possible risks involved.

In the aftermath of 2008’s global financial meltdown, China’s financial system seemed to have emerged unscathed. The country’s economic configuration, often dubbed “Capitalism with Chinese characteristics” by Chinese officials, has been proposed by economists around the world as a viable alternative to the more liberal Western economic system. US financial institutions, deemed “too big to fail”, required emergency government bailouts. In contrast, the major state-owned banks in China, notably the big four—Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China—have only grown in monetary value and provided for domestic development. However, this image of resilience and strength brought on by the banks’ substantial market capitalization, some of the highest in the world, may only be superficial. Carl Walter, a 20-year banking veteran in China, paints a gloomier picture of the country’s complicated and impenetrable banking system.

Walter, whose career as an investment banker in China, involved several restructurings of state-owned enterprises and domestic as well as international initial public listings, was both an observer as well as a participant in the construction of China’s financial infrastructure. He worked as the Chief Operation Officer of China’s first joint venture investment bank—China International Capital Corporation. Over the last decade, he served as JP Morgan’s China Chief Operating Officer as well as CEO of its China banking subsidiary.

Walter encapsulated his remarkable experiences in the book Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, co-authored with Fraser J.T. Howie, an investment banker in the Asia-Pacific region. Walter’s thesis audaciously confronts the buoyancy surrounding the aura of China’s financial development, challenges the underlying fragility of state-controlled banking, and pinpoints the much needed reforms across various building blocks of the economic structure. In the following conversation, Walter opens up about his past experience as well as the future trajectory of the financial system in China.

Q. Fragility within the banking system is a recurring theme throughout your book. Can you identity the areas of biggest concern within China’s banking sector? How would you, as a foreign participant in China’s banking sector, prioritize the reforms of state-owned banks?

A. The big five banks including Bank of Communications were restructured a decade ago and then listed. But because the state owns everything, the bad debt associated with the banks never really went away, although its relative size has been reduced by China’s rapid growth during that time. [The] trouble is that the banks have been used as a part of fiscal policy to stimulate GDP growth following the 2008 financial crisis. In just these past five years China’s total banking assets have grown to exceed GDP by nearly 2.5 times and are more than 1.5 times the size of the entire US banking system. At the same time bad loan ratios are less than 1%. This is impossible and this is the reason that banks in mainland China now trade on the Hong Kong market at less than book value: no one believes their accounting.

I think this time is a bit different than what had occurred in 1998; most of the bad debt is on the books of the smaller banks owned by provincial or city governments, but in the end it doesn’t matter since these banks get most of their funding from the big banks through the interbank market. So this time around the banking crisis is really a fiscal crisis for local governments since they most certainly do not have the funds to recapitalize their own banks. Of total bank capital, over 50% is held by the big state banks, China’s smaller local banks are woefully undercapitalized.

Why does this matter? Well with bank balance sheets loaded by loans that will not be repaid, lending capacity in the entire economy has shrunk, making even good loans hard to make. In China’s investment-driven economy, a slowdown in GDP growth is inevitable unless the government once again fixes the banks.

Q. Could you dissect the state of shadow banking within the context of China’s state-controlled financial domain? How have non-banking financial intermediaries driven growth on a national level and in what ways are they making China’s financial foundation vulnerable?

A. According to an international definition, shadow banking means credit extension outside of the formal banking system. China’s regulators averted their eyes when banks began to work with trust companies to “securitize” their loan portfolios after the outbreak of the crisis. Why, because it allowed banks to continue lending within the regulatory framework set out by the regulators. But just as bank credit extension, whether through loans or bonds, got out of control, the scale of these products also took off. The problem is that no one knows exactly how much is outstanding. There are estimates out there with a range of $2-5 trillion, nearly one-third of China’s GDP.

We do know that 170 banks have offered over 14,000 such products, nearly 50% by 147 banks you have never heard of — small city commercial banks. These banks have neither the expertise nor the management control mechanisms to create and manage such products and their involvement represents a breakdown in bank regulation.

To date only 21 transactions have had difficulty and are being worked out by the officials. What is clear is that there must be more problems and without doubt, the bank involved in offering or arranging the product will ultimately be the one that must fund the solution. Either that or Beijing will have to allow small banks to go bankrupt. This would be a big decision. Only Zhu Rongji (former Chinese Premier) has ever done this, when he allowed Guangdong International Trust and Investment Corporation to be bankrupted.

So no doubt shadow banking has added some credit to the system and contributed to GDP growth, but the question is does China need another coal mine or road to nowhere?

Q. Last year, the government announced that it would license three to five private banks. Will the emergence of these few institutions mitigate the fragility you have discussed in the book or is the move insufficient in producing real results in the already distorted banking system? How do you see internet finance as a potentially disruptive force for China’s brick and mortar banks?

A. Now we know that this announcement really had to do with Alipay (similar to Paypal) and Tencent both of which will receive a banking license. This is a solution attached to the wrong problem just as wealth management products (WMPs) are solutions attached to the wrong problems. As you well know, Alibaba and Tencent are companies involved in selling things and that credit cards are not yet all that widespread in China. Consequently prospective buyers leave small amounts as deposits with these companies to facilitate easy purchases. When Alipay suddenly found itself with all this money on hand, it began to act as a fund management company. If the funds are money market type of funds, that is, invested in government bonds and the like, then there is little risk. But they began offering rates significantly higher than bank deposits and attracted even more money. While this may add some pressure to the major banks, I believe there is a limit to the amount of funds they can attract.

Certainly these entities must be regulated but to turn them into commercial banks makes no sense at all except it allows policy makers to say they are taking action on the inability of state banks to loan to small and medium-sized enterprises. If banks cannot or will not do it, how can Alipay Bank be able to do it? Wrong solution to this problem! This will only end in adding bad credit to the system.

Q. Despite the global financial crisis, some Chinese banks are expanding overseas. What are some underlying risks for the rapid and large-scale expansion? How would the global ambition of these Chinese banks affect the domestic and international financial configuration?

A. Chinese commercial banks should follow their client base overseas, it’s good for the corporations and good for the banks; both will learn how to operate internationally and this expertise will be brought back to China. Given Chinese corporate culture I doubt there will be major expansions–after all, 2008 offered the best chance to expand by acquisitions almost anywhere in the world, yet Chinese banks did very little at a time when their balance sheets were still very strong.

The risk is simply that China’s banks do not fully know how to operate internationally yet, but after the initial learning curve, they will learn over the next decade as China’s companies become more international.