Chinese Banks - "These Things Aren't Banks"

An oldie but a goodie.  Interview with Victor Shih and Carl Walter (watch here) on the distorted banking system and incentives of China and how it may unravel.

Here is a partial picture (in very simplistic terms) of how I see it:

1. China has gone through years of economic growth (productivity improvement) through introducing capital equipments to China's cheap labor force.  This process has slowed in the last few years with growth driven by fixed asset investment (ie. infrastructure and real estate).
2. Fixed asset investments have been productive in the early years.  Urbanization has driven the need for real estate.  Better ports, roads, transport systems, etc. is important to furthering productivity.
3. Local government, SOEs and government ministries (with distorted incentive system and corruption) found that it was easy to drive GDP growth through fixed asset investment.  Land sales were easy as real estate prices kept going up and real estate developers were able to get relatively cheap borrowing from the banks.  Infrastructure construction was a function of borrowing from the banks and throwing money at the projects.  Everyone was making money!
4. How is this possible?  The key is that banking system in China is not structured to make commercially viable loans (ie. allocate capital wisely).  Loans are made primarily through relationships (fueled by corruption) and directed towards SOEs and local governments (indirectly, as local governments are generally prohibited from borrowing).
5. As productivity of various fixed asset investments decline, the massive credit binge (bank lending) is leading to rampant inflation throughout the system.
6. The central government is attempting to contain the issue through imposing various restrictions and mechanisms on banks (eg. changing capital requirements, reserve requirements, limiting total loans made available, etc.).  Problem is these policy 'tweaks' don't fixed the underlying problem - *distorted incentives* throughout the system!
7. Local governments and banks have found ways around the central government policy restrictions by setting up various trust vehicles to obtain funding directly/indirectly from banks (read here).
8. As the central government starts to close in on these trust vehicles, we see a sudden surge in local financing companies and credit guarantee companies prop up around the country that charge exorbitant interest rates (well north of 20-30%+).  Many of these local financing companies are setup by SOEs (like China Mobile, read here) which can still borrow cheaply from the banks, but able to lend out at exorbitant rates (what a great scheme!).
9. Bad loans are on the rise (read here), but banks are more than willing to roll them over and not take a loss.  Now the central government is asking banks to *not* roll over the debt (read here).
10. This is like plugging a leaking dam.  We shall see how it unfolds.

This is obviously an oversimplification of the current situation.  I can write a book on this.  But hopefully this suffices to describe things in broad strokes.