China’s recent efforts to tighten controls on wealth management products, part of what is called the country’s “shadow banking market”, are positive for banks’ credit ratings, although this issue will continue to affect banks’ credit profiles, Moody’s Investor Service says.

The report estimates that core Chinese shadow banking products - those that are relatively non-transparent, loosely regulated, and carry elevated credit risk - stood at at total of RMB21 trillion ($3.41 trillion) at end-2012, or 39 per cent of 2012 gross domestic product.

The report is the latest commentary about such products in recent months; they have raised fears that the world’s second largest economy has a banking system vulnerable to investor hunger for yield. Some reports have even likened these wealth management products to “Ponzi” schemes.

"Ultimately, the impact from shadow banking on banks will depend on the amount, timing and allocation of potential losses, variables that are difficult to assess at this point, given the lack of transparency and the fast-evolving nature of shadow banking in China," Bin Hu, a Moody's vice president and senior analyst, said in a statement.

"We recognise that, even in more advanced economies, shadow banking remains a key channel of credit intermediation that complements the formal banking system. Its growth in China has provided borrowers who have limited or no access to regular bank loans with an alternative source of funding, thus reducing potential pressure on banks to finance less credit-worthy segments of the economy,” the rating agency said.

"Nonetheless, we reflect shadow banking as a negative credit issue in our analysis of Chinese banks. In our view, the opacity associated with shadow banking products and the threat of loss and contagion outweigh their potential benefits of diverting riskier borrowers from the formal banking system," added Hu.

Hu was speaking on the release of a new Moody's report, titled, Risks to China's Lenders from Shadow Banking: Frequently Asked Questions.

The report notes that China's banks have significant exposures to shadow banking activities, through (i) their involvement in the structuring and marketing of WMPs, and (ii) their lending to companies and individuals that are active in shadow banking.

Among the key themes examined in the report are what constitutes a shadow banking market, the size of China's market, the drivers behind its growth, the role of WMPs, the risks to the banking system, and recent steps to impose some form of regulation.

“Shadow banking involves credit intermediation outside the regular banking system, which allows borrowers to circumvent banks' formal underwriting standards. As a non-transparent and less-regulated form of credit extension, shadow banking can stoke asset bubbles and may pose risks to financial stability. Illustrating these risks, some large European and US banks sustained severe losses in recent years from exposures to subprime lenders, structured investment vehicles, sponsored money market funds, and other off-balance sheet conduits, all of which are examples of shadow banking,” Moody’s said.

A common practice – which reports say Chinese regulators are trying to stop – is one in which banks shift bonds back and forth between their own balance sheets and the WMP accounts they manage for clients, allowing them to deliver promised payouts to WMP investors, even if the underlying bonds have not yet matured or have declined in value. Such transactions have also enabled banks to temporarily shift WMP funds back onto bank balance sheets at quarter-end, as a way to window dress their financial statements by boosting the customer deposits they report.

There have been concerns that such fund “pools” allow inflows from the sale of new products to deliver promised returns on products already sold – similar to the sort of Ponzi scheme structures that are typically treated as criminal operations in countries such as the US.