Northwestern University's Victor Shih has described China's banking system as plagued by 'endless moral hazard.'

Financial institutions aren't just sometimes too big to fail, they can also be too small to fail too, or simply just barred from failure for the sake of it. What makes the problem intractable is that it's in everyone's near-term interest to keep playing ball.

FinanceAsia:

Shih refers to the situation as a moral hazard because he believes that no matter how much trouble a bank may get itself into, or whether it is in the wrong, the central bank will bail it out. This differs from Western markets, where there is much more accountability in the governance system and it is still possible for a big bank to go bankrupt.

In the short-term, Shih believes it is difficult to imagine a financial crisis in China. "Crises are caused by a sudden withdrawal of liquidity due to the lack of confidence in the market," Shih said. "With common knowledge of this ultimate backstop, actors in the system will rarely panic."

We realize that most TMG readers have known about these problems before, but we feel Mr. Shih provides an interesting framework for understanding the situation when he describes it as an endless cycle of 'borrower-banker-regulator' collusion.

He also provides a nice concrete example involving the manager of a national bank being paid 'special bonuses' to fund a local government's favored projects:

One example of this became known in 2008 when it emerged that Liu Changming, head of Bank of Communications (Guangdong), had made Rmb10 billion of loans over four years. This was almost a sixth of all loans that were payable at the branch.

Changming formed shell companies to borrow large sums from the bank, which he then lent to various businesses at high interest. In the end, he racked up almost Rmb5 billion in non-performing loans. The peculiar twist to this story is that when a Ministry of Finance (MOF) auditor found the irregularities in Bocom's books, the local prosecutor's office arrested the auditor for taking a bribe.

Eventually, the central government stepped in and ordered the MOF and the police to pursue the case. In the long-run though, it had very little impact on the tightening of accountabilities.

Shih noted that regulators now allow Bocom to roll over the bad loans and value seized assets optimistically to cover up the non-performing loans. What this demonstrates is that when a safety net is all-encompassing it can lead to a misallocation of capital as the state guides cash flows in order to satisfy policy objectives.

This anecdote shows how even when a problem is found, it is simply covered up and remains hidden in the books. Even when it is found it isn't fixed. It's like everyone is in on the ruse, and yet is playing the opposite part as the fool at the same time.

The near-term upshot of this all, according to Mr. Shih, is that the threat of a sudden crisis any time soon is actually small given substantial capacity for the system to keep sheltering financial players and burying bad loans. That's probably the major macro take-away from his view.

The long-term-broken system lends substantial near-term stability which Mr. Shih seems to believe can be sustained for now, despite his criticism.

That's what makes the China bubble so tricky to play. It'd be all too easy if broken systems broke down when they should.