Finance

Shadow banking — a term coined in the U.S. in 2007 — refers to financial services offered outside the formal banking system, which is highly regulated.
China’s property sector, an estimated one-fourth of the economy, lies at the intersection of shadow banking, local government finances and household assets.
Today, Beijing’s problem is it needs to offset a crackdown on shadow banking and real estate developer debt with other kinds of economic support.

Pictured here are models of a real estate development in 2005 in Shanghai, as China’s property boom was gathering steam.
China Photos | Getty Images News | Getty Images

BEIJING — China’s real estate problems have again drawn attention to the world of shadow banking and the risks it poses to the economy.
Shadow banking — a term coined in the U.S. in 2007 — refers to financial services offered outside the formal banking system, which is highly regulated.

In contrast, shadow bank institutions can lend money to more entities with greater ease, but those loans aren’t backstopped in the same way a traditional bank’s are. That means sudden and widespread demand for payment can have a domino effect.
On top of that, limited regulatory oversight of shadow banking makes it hard to know the actual scale of debt – and risk to the economy.
In China, the government has sought in the last few years to limit the rapid growth of such non-bank debt.

Developers were able to borrow liberally from shadow banks, bypassing limits on borrowing for land purchases.

Logan Wright
Center for Strategic and International Studies

What makes the country’s situation different is the dominance of the state. The largest banks are state-owned, making it harder for non-state-owned businesses to tap traditional banks for financing.
The state-dominated financial system has also meant that until recently, participants borrowed and lent money under the assumption the state would always be there to provide support — an implicit guarantee.

Estimates of the size of shadow banking in China vary widely, but range in the trillions of U.S. dollars.

Shadow banking and real estate

China’s property sector, an estimated one-fourth of the economy, lies at the intersection of shadow banking, local government finances and household assets.
Real estate companies bought land from local governments, which needed the revenue and the economic benefits of regional development. People in China rushed at the opportunity to buy their own home — or speculate on property – as prices skyrocketed over the last two decades.

“Developers were able to borrow liberally from shadow banks, bypassing limits on borrowing for land purchases,” Logan Wright, Center for Strategic and International Studies’ Trustee Chair in Chinese Business and Economics, said in an April report.
“As a result, land prices continued rising, with developers then pushing up housing costs to maintain margins.”
According to Wright, Beijing’s recent restrictions on shadow banking pushed the always aggressive developers to turn to other sources of financing to repay existing shadow bank loans. He noted that meant developers started relying more on pre-sales of apartments to homebuyers — via mortgages — and slowing construction to save costs.

The deleveraging campaign that China’s leadership launched in 2016 to reduce systemic financial risks is the only logical starting point to explain how China’s structural economic slowdown began

Logan Wright
CSIS Trustee Chair in Chinese Business and Economics

Then the government cracked down on developers in earnest in August 2020 by setting limits on debt levels.
After decades of rapid growth, Chinese property giants such as Evergrande and Country Garden have successively struggled to repay debt. Their cash flows have dried up, largely due to falling home sales.
Almost simultaneously, news surfaced about trust fund Zhongrong’s inability to repay investors on some products. The fund had lent money to developers.

Hiding money in trust funds

It’s becoming clear that at least a few of the struggling real estate companies had kept some debt off the books.
“Recent disclosures have raised questions about the lax controls and aggressive accounting practices of developers during the boom years,” S&P Global Ratings said in late August.
This summer, property developer Shimao revealed it owed far more debt than previously disclosed — unbeknownst to its former auditor PricewaterhouseCoopers, the S&P report pointed out. PwC resigned as Shimao’s auditor in March 2022.
“Some of those funds, those hidden debt were provided by the trust companies,” Edward Chan, a director at S&P Global Ratings, told CNBC in a phone interview.
“These trust companies were basically part of the shadow banking system in China.”

Trust funds sell investment products, typically to wealthier households.
As of end March, about 7.4% of trust funds’ value in China was exposed to real estate, the equivalent of about 1.13 trillion yuan ($159.15 billion), according to China Trustee Associations data cited by Nomura.
They estimate the actual level of developers’ borrowings from trust companies is more than three times greater — at 3.8 trillion yuan as of the end of June.
“Some trust products that were invested in the property sector may not have disclosed the actual use of funds or intentionally made this information less transparent to circumvent financial regulations,” the Nomura report said.

Economic consequences 

Banks in China also used trust companies to hide the true level of risk on their balance sheets, while making money by lending to restricted borrowers — such as property developers and local governments, said Wright from CSIS.
He estimated shadow banking represented nearly one third of all lending in China from 2012 to 2016 — and that after Beijing’s crackdown on the sector, China’s credit growth was cut in half.
Today, Beijing’s problem is it needs to offset a crackdown on shadow banking and real estate developer debt with other kinds of economic support.

“The deleveraging campaign that China’s leadership launched in 2016 to reduce systemic financial risks is the only logical starting point to explain how China’s structural economic slowdown began,” Wright said.
“China’s economic growth over the next 5 to 10 years will depend upon how successfully and efficiently the financial system can shift its resources away from property-related lending and local government investment projects toward more productive private sector firms,” he said.
“Otherwise, China’s economic growth rates will continue to slow over the next decade to 2 percent or below.” More

The appeal of a diamond, for a ring on finger or to string on a necklace, rests on how sparkly it is. Its precise value is determined by how well the stone is cut, its colour, its size (also called its “carat”) and whether it contains flaws. The clearer, heavier, closer to colourless and more perfectly cut the rock, the better.The appeal of a diamond for an investor is that, in addition to being nice to look at, it has historically offered a steady return on investment. Given the opacity of the market, and the broad variety of gems that are available, long-run price data are scarce. But a paper by Luc Renneboog of Tilburg University, which was published in 2015, analysed thousands of auctions each year, finding that the average return between 1999 and 2012 rivalled those of stocks and property. Holders of diamonds would have earned a handsome 8% or so a year.Recently, though, these steady returns have given way to enormous volatility. De Beers, a consortium that has long monopolised the supply of diamonds, has reduced the price of two-to-four carat uncut stones—a popular category because they can be made into one-to-two carat engagement rings—by 40%, according to Bloomberg, a news service. On September 13th the company announced that it would re-run its iconic “a diamond is forever” advertising campaign in an attempt to boost demand.Stable returns in the past were partly brought about by steady demand. Just as with the investment case for gold, another rare and precious commodity, the logic for holding diamonds tends to be strongest during periods of economic uncertainty. At the same time, the main use of diamonds is in jewellery, which means that prices have tended to do well during periods of prosperity, too.But the most important factor was monopolistic supply. For more than a century De Beers managed to dominate the production of gems. This market structure facilitated steady price increases in two ways, as Mr Renneboog has noted. First, by stockpiling supplies De Beers created scarcity. Second, the firm curbed speculation, and the volatility it brings. Although De Beers controlled some 80% of the global supply of diamonds in the 1980s, since then its share has been eaten into by competitors, which include Alrosa, a Russian rival. The company now produces just a third of global supply.Another problem is emerging from laboratories. They are producing artificial gems, which are made by applying pressure to carbon, rather than digging stones from the ground, and are identical to the naked eye. Such stones have been available since the 1980s, but even as recently as 2018 made up a tiny fraction of the market, at just a few percentage points. In the years since more lab-grown jewels have entered the market—and their market share has risen to around a tenth.De Beers may have accidentally hastened this transition. The company began to sell lab-grown diamonds at rock-bottom prices in 2018, when such stones fetched about 80% of the price of mined ones. The goal was to differentiate between the two types of gems, in order to diminish the appeal of lab-grown stones. The Clear Cut, a New York-based purveyor of engagement rings, has adopted guerrilla marketing tactics to make the same point. It offers customers who buy a ring worth $10,000 or more a free lab-grown alternative, which can be used as a “travel ring” when visiting dubious places. Many lab-grown stones now fetch just 20-30% of the price of similar mined stones.De Beers argues that, as the supply of lab-grown gems accelerates, the price gap between the two types of stone will continue to widen, making the newcomers unappealing for engagements. Yet if recent price movements are anything to go by, the tactic appears likely to backfire—after all, mined prices are plunging in the wake of lab-grown ones.Admittedly, this may not be entirely the result of a structural shift in the market. American couples date for about three years before getting engaged, and thanks to covid-19 very few people were out and about meeting potential husbands or wives in 2020. An unusually small number of people are probably getting engaged this year.Still, this is the sort of fluctuation an all-powerful diamond cartel would have been able to smooth out by reducing supply. Slashing prices instead is a clear indication of diminished market power. That is good news for those looking to pop the question or acquire a new trinket. It is less appealing for those considering investing in the gems. ■ More

“Nothing is possible without people. Nothing is lasting without institutions,” noted Jean Monnet, one of the European Union’s founding fathers. The growth of the European Central Bank (ecb) from humble beginnings, as the guardian of a nascent currency, to one of the great powers in European politics might have surprised even the master technocrat himself. Having recently turned 25, the institution is so mighty that it now faces a tough question. Does it know when to stop?The ecb is unique in that it has no political overlord or fiscal counterpart. Its independence is enshrined by treaty, the closest the eu has to a constitution. Its mandate puts price stability front and centre. In a second part policymakers are instructed “to support the general economic policies of the eu”, which include growth and employment, in a manner similar to the dual mandate of the Federal Reserve, but may also be stretched to include climate policies or “de-risking” relations with China.Throughout the ecb’s history, its officials have assumed extra responsibilities. In many cases they were forced to do so. In the midst of market turmoil during the sovereign-debt crisis of the early 2010s, Mario Draghi, then the bank’s president, calmed investors by promising to do “whatever it takes” to protect the euro. During covid-19 and under Christine Lagarde, the current president, the ECB bought €1.7trn ($2trn) in public debts to arrest doubts about governments’ liquidity. She followed this up by announcing another bond-buying programme last year, when inflation threatened to send interest rates on Italian bonds soaring.In all but name, then, the ecb has become the lender of last resort to euro-zone governments. The bank is at pains to stress that its bond-buying programmes come with strings attached. Indeed, in order to sidestep the treaty’s ban on financing governments, officials must combine a monetary-policy justification with adherence to the eu’s fiscal rules and the need for sustainable debt. As such, “ecb lawyers have to be among the most innovative in the world,” says Sander Tordoir of the Centre for European Reform, a think-tank. Rather than governments leaning on the central bank to help out, as can happen elsewhere in a crisis, the ecb enforces “macroeconomic reasonability”, as Francesco Papadia, a former ecb official, puts it.Geopolitics are now pushing the ecb into a still more sensitive role. Take swap lines. The bank decides whether to set them up. If European banks urgently need dollars, for example, the ecb could swap euros for the currency with the Fed. Of the two large non-euro eu members, Poland benefits from a limited swap line with the ecb; Hungary does not. “Whether Ukraine, for example, gets [one] should be a joint decision with finance ministers, and not the ecb’s alone,” argues Shahin Vallée of the German Council on Foreign Relations, a think-tank. Similarly, the ECB is a powerful voice in a debate about what should happen to Russia’s frozen central-bank assets, preferring to leave them untouched. It also objects, on legal grounds, to attempts to rechannel some imf special-drawing rights, which can be used as foreign-currency reserves, to development banks.Yet the ecb is not just responding to events. This can be seen in its promotion of the euro—something for which its mandate does not explicitly call. As Ms Lagarde recently told The Economist: “If there is more trade in euros, we need to provide the liquidity supporting that trade. An international euro is a force for stability.” One way in which it is planning to boost the euro is through a digital currency, which may help facilitate international transactions. It has gone further than the Fed, which is nowhere near to issuing one and is more worried about political approval.Climate change is another area where the ecb is playing a role. As the bloc’s main banking supervisor, it must assess emerging risks. “It is no longer controversial that the climate crisis translates into financial risk, and is thus squarely within our mandate,” says Frank Elderson of the ecb’s executive board. The results of an ecb climate stress test, published on September 6th, show that a faster energy transition will lower banks’ credit risks in the medium term. Thus green thinking will increasingly inform the ecb’s risk management, bond-buying and collateral policies.Ms Lagarde argues more could be within the bank’s mandate: “All European bodies, from the European Parliament to member states are committed to the Paris Agreement’s climate targets.” One policy being debated is a green version of the ecb’s targeted-lending operations. These have been employed so far as monetary-policy tools, encouraging financial institutions to lend to companies and households. Taking green considerations into account when handing out cash would mean the bank conducts outright climate policy, which would go beyond anything the Fed would consider doing.The danger in all this is that the ecb does too much. There is no desire among national governments to put the bank on a leash. Indeed, it may offer a way to achieve things that politicians cannot, for fear of public backlash. Perhaps aware of its political power, countries are nominating politicians to the ecb’s governing council. The president herself was previously France’s finance minister; Luis de Guindos, the bank’s vice-president, was Spain’s. Yet the more the ecb ventures into controversial areas, the greater the risk its legitimacy is eroded. For the moment, both politicians and central bankers are happy. Will citizens one day start to object? ■ More

David Wadhwani, senior vice president of digital media for Adobe, speaks during the launch of Adobe Creative Cloud and CS6 in San Francisco, April 23, 2012.
David Paul Morris | Bloomberg | Getty Images

Check out the companies making headlines in midday trading.
Redwire — The space infrastructure stock soared 5.6% Wednesday after Roth MKM initiated research coverage of the company with a buy rating. The firm said Redwire, which went public via a special purpose acquisition company in 2021, has “several billions worth of pipeline revenue opportunity.”

Corteva — The seed and crop protection solutions provider added 0.7% after launching Reklemel, a new product that will help protect a variety of food and row crops from plant-parasitic nematode damage, according to a Wednesday press release from the company.
Moderna — Shares of the vaccine maker rose 3.2%. The action comes a day after the Centers for Disease Control and Prevention cleared updated Covid vaccines from Pfizer and Moderna for Americans ages 6 months and up, following approvals from the U.S. Food and Drug Administration. The mRNA vaccines are designed to target a relatively new omicron subvariant called XBB.1.5.
Citigroup — Shares advanced nearly 1.7% after the bank’s CEO Jane Fraser announced a corporate reorganization Wednesday amid a stock slump. The move will divide Citigroup into five main divisions, ridding the company of its two main divisions that catered to consumers and large institutional clients.
Airline stocks — American Airlines tumbled 5.7% after it slashed its third-quarter profit estimates due to higher fuel prices and costs from a new pilot labor agreement. Low-cost carrier Spirit Airlines fell about 6.3% after it also cut its summer profit estimates due to higher costs.
Xpeng, Nio — U.S.-based shares of Chinese electric vehicle makers Xpeng and Nio dropped 3.1% and 4.7%, respectively, after the European Commission said it is launching an investigation into subsidies given to electric vehicle manufacturers in China.

Adobe — Stock in the software company added about 2.1% in midday trading ahead of quarterly results Thursday. Analysts polled by FactSet forecast an adjusted $3.98 per share on $4.866 billion in revenue. Traders have also signaled bullish sentiment toward the stock ahead of earnings, due to the continued excitement over artificial intelligence.
Ford Motor, General Motors — The auto stocks advanced after UBS said both were buys. Ford added 1.5%, while General Motors climbed 0.6%. The firm noted that Ford’s pro business, its commercial segment, should show stronger-than-expected resiliency. 
— CNBC’s Alex Harring, Hakyung Kim, Brian Evans, Samantha Subin and Tanaya Macheel contributed reporting. More

Jim Cramer on CNBC’s Halftime Report.
Scott Mlyn | CNBC

KeyCorp (KEY) reiterated its financials Tuesday, sending its shares higher — a rally that’s been seen in the wider financial sector recently. The stock, however, edged lower after Wednesday’s open on Wall Street. That’s because, according to Jim Cramer, investors are focusing their attention on big banks, rather than smaller regionals.

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“There’s a big split right between investment banks, big money centers and the regionals,” Cramer said, cautioning that the recent banking sector rally may not be sustainable.

Wells Fargo (WFC) and Morgan Stanley (MS) — two holdings of Cramer’s Charitable Trust, the portfolio used by the CNBC Investing Club — have notched gains in recent sessions as well following a challenging year amid a crisis of confidence in the entire industry after the March failure of Silicon Valley Bank.

Here’s a full list of the stocks in Jim’s Charitable Trust, the portfolio used by the CNBC Investing Club. More

Citigroup CEO Jane Fraser announced a corporate reorganization Wednesday, saying the move would cut down management layers and accelerate decisions.
Fraser, closing in on her third full year atop Citigroup, said in a release that the firm’s five main business lines would report directly to her.
The changes will include job cuts, though the company hasn’t decided on a number yet, according to people with knowledge of the matter.

Jane Fraser CEO, Citi, speaks at the 2023 Milken Institute Global Conference in Beverly Hills, California, May 1, 2023.
Mike Blake | Reuters

Citigroup CEO Jane Fraser announced a corporate reorganization Wednesday, saying the move would cut down management layers and accelerate decisions.
Fraser, closing in on her third full year atop Citigroup, said in a release that the firm’s five main business lines would report directly to her.

The changes will include job cuts, though the company hasn’t decided on a number yet, according to people with knowledge of the matter.
This is breaking news. Please check back for updates. More

A member of the Mississippi National Guard receives a dose of the Moderna COVID-19 vaccine in his arm, in Flowood, Mississippi.
Rogelio V. Solis | AP

Check out the companies making headlines before the bell.
Moderna — Moderna shares rose more than 3% in early trading after the Centers for Disease Control and Prevention recommended updated Covid vaccine shots for all Americans ages 6 months and older. Pfizer shares added 0.2%.

Apple — Apple dipped 0.4% before the bell, one after debuting its latest iPhone model and multiple updates, including a new Apple Watch and revamped AirPods.
Ford — Shares of the automaker rose 1.5% premarket after UBS analyst Joseph Spak initiated research coverage with a buy rating and a $15 price target implying 21% upside. Spak said Ford’s pro business, its commercial segment, should show more resiliency than expected and potentially mitigate downsides from issues in blue and electric car models.
BP — Shares rose more than 1% before the open one day after BP CEO Bernard Looney resigned a little more than three years after assuming the post. BP shares in the U.S. closed down 1.3% Tuesday, reversing an early 2.9% gain.
Xpeng, NIO — U.S.-based shares of Chinese electric vehicle makers Xpeng and NIO fell more than 3% and 2%, respectively, after the European Union said it’s considering imposing anti-subsidy tariffs on Chinese imports to protect domestic producers.
American Airlines, Spirit Air — American fell 3.1% after lowering its third-quarter earnings guidance, citing higher fuel prices and costs from a new labor agreement. The airline now expects per-share earnings in the range of 20 cents to 30 cents, lower than prior guidance of 85 cents to 95 cents. Spirit dropped 3.9% after cutting its summer profit forecast owing to higher costs.
— CNBC’s Samantha Subin, Pia Singh, and Sarah Min contributed reporting More

Arm is expected to begin trading Thursday in the year’s biggest listing. Instacart and Klaviyo are expected to list as soon as next week.
While they each operate in vastly different parts of the tech universe, the companies have one important thing in common: Goldman is a key advisor.
But with the sought-after title of lead advisor comes added scrutiny if the deals flop.

David Solomon, Goldman Sachs interview with David Faber, September 7, 2023.

The return of large tech IPOs this week after a prolonged drought isn’t just a test of investors’ appetite for risky new offerings — it’s a key moment for Wall Street’s top advisor, Goldman Sachs.
Chip designer Arm is expected to begin trading Thursday in the year’s biggest listing. Delivery firm Instacart and marketing automation platform Klaviyo are expected to list as soon as next week.

While they each operate in vastly different parts of the tech universe, the companies have one important thing in common: Goldman is a key advisor.
The stakes are high for everyone involved. Last year was the slowest for American IPOs in three decades, thanks to sharply higher interest rates, rising geopolitical tensions and the hangover from 2021 listings that fared poorly. Successful IPOs from Arm and others will boost confidence for CEOs waiting on the sidelines, and activity there would help revive other parts of finance including mergers and financing.
That would be meaningful for Goldman, which is more dependent on investment banking than rivals JPMorgan Chase and Morgan Stanley. Amid the industry’s slump, Goldman has suffered the worst revenue decline this year among the six biggest U.S. banks, and CEO David Solomon has contended with internal dissent and departures tied to strategic errors and his leadership style.
“This is the core of the core of what Goldman Sachs does,” Mike Mayo, Wells Fargo banking analyst, said in a phone interview. “Expectations are high, and they’re likely to meet those expectations. Should they fall short, there will be far more questions than anything we’ve seen so far.”

Lead-left bank

Goldman is lead-left advisor on Instacart and Klaviyo, meaning their bankers drive decisions, coordinate other banks and typically earn the biggest portion of fees. On Arm, Goldman shares top billing with JPMorgan, Barclays and Mizuho. Goldman also was named the deal’s allocation coordinator.

But the sought-after title of lead advisor comes with added scrutiny if the deals flop.
If shares of Arm or the other two IPOs fail to trade for a premium to the list price in coming weeks, dark clouds could form over the nascent market rebound. For Goldman, perceptions of a bungled process would feed doubts about the company under Solomon.
Unlike the bank’s unfortunate foray into consumer finance, Goldman’s position atop Wall Street’s league tables hasn’t budged. The bank has actually gained share in advisory and trading since Solomon took over in 2018.
But even in its traditional stronghold, there is room for cracks. Goldman is being investigated for its role advising Silicon Valley Bank in the days before its collapse.

What’s Arm worth?

Initial public offerings can be tricky transactions to navigate. Advisors need to properly gauge interest in shares and balance demands from clients while pricing shares so investors see upside.
While Arm’s offering is reportedly seeing high demand, there are nagging doubts about the company’s valuation, its large exposure to China and its ability to ride the artificial intelligence wave. The SoftBank-owned company’s valuation has waxed and waned in recent weeks, from as high as $70 billion initially to the roughly $55 billion that represents the top end of a target share price of $47 to $51.
“We believe investors should avoid this IPO, as we see very limited upside ahead,” David Trainer, CEO of research firm New Constructs, wrote Tuesday in a note. “SoftBank is wasting no time by offering Arm Holdings to the public markets, and at a valuation that is completely disconnected from the company’s fundamentals.”
Further, Arm is selling an unusually small slice of its overall stock, about 9%, which helps drive scarcity. That small public float means new investors will have fewer rights related to voting power and corporate governance, Trainer noted.
The IPO is expected to raise more than $5 billion for Arm and generate more than $100 million in fees for its bankers.
There are more than 20 tech companies weighing whether to go public in the next year or so if conditions remain favorable, according to bankers with knowledge of the market. While some have begun taking steps to list in the first half of 2024, according to the bankers, the situation is fragile.
“If those three don’t go well, it doesn’t bode well for the rest of the IPOs or M&A because people will lose confidence,” one of the bankers said. More