Systemic Risk in China The Harmless Debt Crisis Written By Raghav Madhukar
Graphic By Michelle Ren Zhang
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ystemic risk (SRISK) is the quantum of externality that a firm-level failure can impose on the broader financial sector. Perhaps the most impactful instance of SRISK in recent history was the 2008 collapse of Lehman Brothers, which led to severe repercussions across financial institutions and securities markets. In today’s global context, Chinese companies collectively carry approximately 30% of the world’s systemic risk, compared to US companies, which account for a mere 7%. This gargantuan concentration of SRISK in China warrants a serious investigation into its various causes and implications.
Systemic Crises and Risk
Systemic crises emerge with low aggregate capitalization in the financial sector. When individual financial firms’ ability to provide financial services to clients is threatened due to low capital availability, other financial firms often step in to fill the gap. However, when capital availability in the aggregate financial sector is insufficient, there is really no scope for other firms to fill the gap - it is in such scenarios that systemic crises materialize. There are broadly two categories of events that trigger such aggregate capital shortage in the financial sector: (1) The economy reels from a shock, or (2) A highly interconnected firm (i.e. a firm with high SRISK) fails. While there is a vast sea of literature on the sources, nature, and implications of economic shocks, the first serious attempt to quantify SRISK was made only as recently as in 2010, by a team of finance researchers at NYU Stern’s Volatility Lab following the publication of a seminal paper titled ‘Measuring Systemic Risk.’ It was determined that an accurate measure of SRISK could be computed as the product of (a) the expected costs to society from a systemic crisis measured per dollar of capital shortage in the aggregate financial sector, and (b) the anticipated contribution of a firm to the aggregate capital shortage. Part (a) represents the potential financial cost that society will have to incur (in dollar terms) in the instance of a crisis. Part (b) represents a firm’s contribution to the expected losses during a crisis (as a percentage). Therefore, SRISK turns out to signify a monetary value.
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Cornell Business Review
SRISK in China As of today, global systemic risk stands at $4.4 trillion, with China single-handedly accounting for $1.3 trillion. Four Chinese banks - Industrial and Commercial Bank of China (ICBC), Bank of China, China Construction Bank, and Agricultural Bank of China - have a cumulative SRISK of more than $660 billion, which constitutes more than 50% of the country’s total SRISK.
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What is even more astounding is that the Bank of China and the Construction Bank of China together hold more SRISK than
These staggering figures from China can be attributed almost entirely to two factors: the size of Chinese banks and the leverage they carry.
Size of Banks
Chinese banks have achieved enormous growth over the past two decades. Nineteen of the 100 largest banks in the world by Net Asset Value (NAV) are based in China four of which top the list. This transformation has been enabled by a combination of various key factors including state intervention, disproportionate corporate debt, and nascent equity and bond markets. Since the turn of the millennium, the Chinese state has relentlessly pursued a strategy of aggressive lending to both retail and corporate consumers alike, even if at times this may have meant compromising on credit quality. However, since the Chinese government regulates monetary policy while also owning and operating banks, concerns regarding undercapitalization, under-profitability, or rising bad debt rarely arise. This is because the central bank can and will always step in, and even print currency if necessary, for the banks’ protection. Thus, China has successfully cultivated and preserved an environment of fearless lending for over
