With the banking and property sectors in turmoil, Jason Bedford thinks the trust industry is next on the chopping block.

Why should you care: Bedford correctly predicted the troubles in China’s banking sector four years ago and he is now setting his sights on the US$2.9 trillion trust industry. It will be worth taking a look at this analysis and what he has to say to form a view on China’s shadow banking sector. This could have big consequences on the economy considering that China’s households put many of their savings into the trust industry.

China’s trust industry is next on the radar for Jason Bedford. Here’s essentially what he thinks is wrong with the industry:

• 14 out of 55 of the trust companies that issued financial statements, reported that close to one-third of their assets are non-performing.
• 13 firms that did not report, could also face huge problems.

To start with, the trust industry in China is considered part of the shadow banking sector and takes in deposits and funds from people to invest in other investments in the economy. It also lends money to firms that can’t get access to the traditional banking system in China.

The kicker here is that the trust industry lent a lot of its money to property developers who have hit a very rough patch in recent years. It is no wonder then many have raised the alarm signals around the trust industry.

I can see the reason why this could be a big source of concern for many investors. Zhongzhi, which is a big shadow bank in China recently reported that it had serious problems of ‘insolvency’, which is a four-letter word equivalent. To say such things revokes past traumas of the 2007/2008 financial crisis where the collapse of Lehman Brothers triggered a widespread panic in the global financial industry.

In economics, we call this the contagion effect. The collapse of a single bank could trigger the collapse of other bigger banks. That bank could owe a lot of money to other banks, and when that bank cannot repay, the other banks don’t have enough funds to pay other people. And when that happens, you will see queues of people outside of all these banks, demanding their money back. Hence, one insolvent bank could trigger cash flow issues for other banks and cripple the whole banking system.

What is the likely scenario of this then? I would say the Chinese government would let some of them fail if that happens. But considering that the sector holds a large amount of Chinese household deposits, they will eventually come to the rescue of some of them by extending credit and funding for them to stay afloat. This has happened many times in history, and it is no surprise that this will happen again. While I think that the shadow banking sector is due for a correction, it is unlikely that the government would let the sector fail.