World Economy

Shadow Banking Cases Threaten to Overwhelm China Courts

Shadow Banking Cases Threaten to Overwhelm China CourtsShadow Banking Cases Threaten to Overwhelm China Courts

Many bankers and economists have been looking at shadow banking in China. But what happens when debtors fail to pay their debts or challenge the lending arrangements?  When parties to shadow lending end up in dispute resolution, it raises unique issues for the institutions that hear those cases.

What few outside of China have noticed is that shadow lending disputes account for an increasingly large proportion of civil cases in the Chinese courts and involve increasingly large amounts of money. The law on shadow lending is particularly unclear and fluid, causing uncertainty for debtors, lenders, and judges, Susan Finder* wrote for The Diplomat.

Government recognition of internet lending and peer-to-peer (P2P) lending, now at an early stage, likely means that many more shadow lending disputes are destined for the already stressed court system.

Shadow Banking Disputes

In China, shadow lending is most often called private lending and involves lending outside the formal banking system. One of the vice presidents of the Supreme People’s Court commented that this is not a legal term, and regulators and judicial authorities have different views of it.

Regulators consider loans made by persons or entities other than commercial banks to be “private lending,” even if they are made by microfinance companies and pawnshops, which have approval to make loans.

The greatest number of shadow banking disputes are heard by the Chinese courts. An increasing number are heard by China’s arbitration institutions, but a loan agreement must have an arbitration clause to be heard by an arbitration institution (and it is more difficult to obtain accurate numbers for those disputes).

It is not easy to obtain detailed national data on shadow banking disputes. According to President of the Supreme People’s Court (SPC) Zhou Qiang’s March 2015 report to the National People’s Congress, in 2014 Chinese courts heard over one million shadow banking disputes, accounting for 20 percent of all civil cases in the Chinese courts.

Zhejiang, nationally known for its active private business sector, led the way with 132,000 cases in 2014 (110,000 in 2013), of which about 15,000 were heard in the Wenzhou courts , with total amounts in dispute of over RMB  86.3. billion ($13.9 billion). 

Legislation on Private Lending

Legislation on private lending is another headache for courts hearing private lending cases. The legislation has to be pieced together from multiple sources, because regulations on loans are only applicable to financial institutions. Moreover, the SPC’s policies on private lending have shifted. The SPC was originally hostile toward loan contracts between companies (upholding PBOC regulations on the subject), but more recently has started to change its position in the last two years, as the government has started to recognize P2P lending and internet lending.

Private lending cases are fraught with legal issues for the judges trying to deal with these disputes.

The number one problem: finding the debtor. In China, the courts serve by process, but in many private lending cases, the defendant has disappeared, leaving the court to serve by notice. Further complicating things, many private lending cases are based on IOUs or other sketchy evidence, or the loan was made in cash rather than by a bank transfer. Once a case is decided, it’s hard to find assets with which to satisfy the judgment.

There’s another level of complexity to many of these cases as well. Private lending has become a business, with many SMEs, micro-credit companies, investment companies, guarantee companies, and chains of companies involved, along with increasing amounts of money. Many listed companies are establishing microfinance companies so that they can earn the maximum legal interest that the courts will uphold (which is four times the bank rate) rather than engage in their traditional business. But the legislation and guidance does not given anyone certainty.

*Susan Finder blogs as the Supreme People’s Court Monitor.