Nicholas Borst

Research Associate

Peterson Institute for International Economics

Shadow Deposits in the United States and China

What is a Shadow Deposit?

• An investment product that acts as substitute for

traditional deposits

• Lack protections like deposit insurance, lender of last

resort, and capital buffers

• The part of the shadow banking system most familiar to

ordinary investors

• Come in the form of money market mutual funds in the

United State and wealth management products in China

2

Regulatory Restrictions on Deposits in the United States

• Regulation Q of the Glass-Steagall Act (1933)

– Implemented in aftermath of Great Depression

– No interest on demand deposits, interest ceiling on time deposits

– Prevent irresponsible competition for depositors amongst banks

• McFadden Act of 1927

– Implemented to give national banks equal competitive footing

– Effectively limits interstate banking by subjecting national banks to state rules

• Bank Holding Company Act of 1956

– Prevents bank holding companies from acquiring banks in other states

3

Money Market Mutual Funds in the United States

• Money market mutual funds emerge in 1971 growth driven by

short-term interest rates above deposit ceiling as a result of

inflation

• Offer higher return than traditional deposits

• Invest in cash-like securities, limits on maximum exposure to

single borrower

• Able to expand rapidly because exempt from interstate

banking restrictions and offer deposit like convenience

• Illusion of safety through stable net asset value (NAV)

4

Short-Term Interest Rate Spikes in 1970s Due to Inflation

5

0

2

4

6

8

10

12

14

Source: Annual Statistical Digest/FRASER, IMF IFS

Federal FundsRate

Treasury BillRate

Reg-Q DepositCeiling (6months to 1year)

Percent

The Growth of Money Market Mutual Funds

6

0%

5%

10%

15%

20%

25%

30%

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

Source: Federal Reserve, BEA, Author's Calculations

TotalFinancialAssets

Percent ofGDP

Millions

Money Market Mutual Fund Failures

Breaking the Buck:

• Community Bankers Mutual Fund (1994)

– Cause of Failure: government bond derivative with a floating rate

– Returned 94 cents on the dollar after intervention by sponsor

– Limited impact on financial system because of strong overall economy

• Reserve Primary Fund (2008)

– Invested heavily in asset-backed commercial paper in 2007-2008

– 1 percent of assets in Lehman commercial paper

– Returned 99 cents on the dollar after year holding period

7

Money Market Mutual Funds During the Crisis

• Rapid withdrawal of funds from money market mutual funds

($300 billion during week of September 15, 2008), shift within

allocations

• Impact on commercial paper market as money market mutual

fund share drops from 38 to 32 percent in Q3 2008. Short-

term financing impacted throughout economy.

• US Treasury forced to guarantee all money market mutual

funds prior to Lehman, Fed creates Commercial Paper

Funding Facility (CPFF) to restore commercial paper market

• These actions now prohibited by Dodd-Frank Reform

8

Wealth Management Products in China

• Emerged in 2004, initially mostly foreign currency

denominated, now almost entirely in renminbi

• Short-term, rolling investment products offered to

depositors issued by banks or by third-parties via banks

• Asset Structure:

– Standard: bond and money market products, bank deposits, equities

– Non-Standard: Credit products, trust investments

– Per new CBRC guidelines, banks must reduce share of non-standard products to 35% of total WMPs or 4% of assets

9

Wealth Management Products in China

• 60 percent of wealth management products have maturity

less than three months, 99 percent less than a year (2012)

• Two-thirds have no principal guarantee, products without a

guarantee are off-balance sheet for banks

• Smaller banks issue more wealth management products

relative to their size and offer higher rates

• Retail customers account for two-thirds of total

10

The Real Interest Rate on One-Year Deposits

11

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

Jan

-07

Mar

-07

May

-07

Jul-

07

Sep

-07

No

v-0

7Ja

n-0

8M

ar-0

8M

ay-0

8Ju

l-0

8Se

p-0

8N

ov-

08

Jan

-09

Mar

-09

May

-09

Jul-

09

Sep

-09

No

v-0

9Ja

n-1

0M

ar-1

0M

ay-1

0Ju

l-1

0Se

p-1

0N

ov-

10

Jan

-11

Mar

-11

May

-11

Jul-

11

Sep

-11

No

v-1

1Ja

n-1

2M

ar-1

2M

ay-1

2Ju

l-1

2Se

p-1

2N

ov-

12

Source: People's Bank of China, Author's Calculations

Real Int Rateon One YearDeposits

Percent

The Spread 3 Month WMP Return and Deposit Rate

12

2.00

2.50

3.00

3.50

4.00

4.50

5.00

5.50

6.00

Jan

-11

Feb

-11

Mar

-11

Ap

r-1

1

May

-11

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

May

-12

Jun

-12

Jul-

12

Au

g-1

2

Sep

-12

Oct

-12

No

v-1

2

Dec

-12

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3

Source: Wind

CityCommercialBanks

ShareholdingBanks

LargeCommercialBanks

SavingsDeposit

Percent

The Growth of Wealth Management Products

13

0%

2%

4%

6%

8%

10%

12%

14%

16%

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

2008 2009 2010 2011 2012

Source: Barclays, NSB, Author's Calculations

Bank-IssuedWMPsOutstanding

Percent GDP

RMB Billions

The Decline in the Share of Traditional Loans

14

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: People's Bank of China

Loan PercentSocial Financing

Regulators Divided Over Wealth Management Products

Zhou Xiaochuan: Shadow banking is an inevitable development in response to needs in the real economy. There are fewer problems with shadow banking in China than in the developed countries (11.2012, People’s Daily)

Fang Xinghai: 99 percent of wealth management products are normal and are no threat to the banking system (02.2013, Wall Street Journal)

Xiao Gang: Wealth management products have a significant liquidity risk. New issuances to pay repay maturing products is fundamentally a ponzi scheme (10.2012, China Daily)

15

Wild West Interest Rate Liberalization

• Banks use to wealth management products to attract and

retain depositors, weaker banks offer higher rates

• Evasion of regulatory restrictions: structure products to expire

before regulator checks loan to deposit ratio at quarterly

close, informal securitization through interbank market

• State of investor education is poor

• No real defaults yet due to government intervention, rampant

moral hazard

16

Lessons from the US?

Paul A. Volcker: “Free of capital constraints, official reserve

requirements, and deposit insurance charges, these money

market mutual funds are truly hidden in the shadows of banking

markets. The funds are demonstrably vulnerable in troubled

times to disturbing runs.”

(09.2011, William Taylor Memorial Lecture)

• US money market mutual fund reform has been slow and

piecemeal due to industry opposition

– SEC regulations in 2010 limit exposure to an individual borrowers and require more frequent disclosure

– Removing the stable NAV for institutional investors is currently under debate

17

Lessons from the US?

• Highly regulated funds can still get into trouble

– US MMMFs more highly regulated than Chinese WMPs

– Linkage to risks in the corporate sector, particularly if risk ratings are incorrect

• Wealth management products may persist after interest rate

liberalization

– Investor habit and regulatory arbitrage

– Will WMPs be immune from the new deposit insurance system and capital requirements?

• Shadow deposits are vulnerable to “bank runs”

– Investor sentiment change rapidly after risks become apparent

18

Possible Reforms

• Money Market Mutual Funds

– Eliminate stable NAV for all MMMFs

– Require capital buffers against potential losses

• Wealth Management Products

– All WMPs should be brought on balance sheet

– Banks should hold capital buffers against potential losses

Conclusion: Shadow deposits are a form of interest rate

liberalization that entails significant potential risks. Regulators

should carefully weigh these risks before allowing them to grow

further.