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Chinese investors who have poured millions into wealth management products have received a rude shock that highlights the risks of the current credit bubble. It is also sure to reverberate throughout China's huge shadow banking system, which is rife with bad off-balance-sheet investments posing as safe vehicles for people seeking higher yields.

Industrial and Commercial Bank of China warned Thursday that it will not rescue clients who have lost money in a three-billion-yuan ($541-million) trust product that it peddled through its branch network in 2010. ICBC, the world's biggest bank in terms of assets, is under no obligation to make good on the losses, because such investments are not typically guaranteed. But many Chinese have assumed that the retail products sold by the state-owned banks, which have raked in fat profits on the often opaque vehicles, carry some sort of protection. Now they must realize that the risks are growing as the credit bubble moves inexorably closer to bursting.

In this not-unusual case, investors were drawn by the 10 per cent yield offered by the issuer, China Credit Trust Co. Ltd. That's tough to pass up when normal deposit rates are closer to 3 per cent, and there are few other alternatives apart from overheated real estate.

China Credit loaned the proceeds from the wonderfully named 2010 China Credit/Credit Equals Gold #1 Collective Trust Product to Shanxi Zhenfu Energy Group Ltd., an unlisted coal company that's on the verge of collapse. Chinese coal is a deeply troubled sector, and it's doubtful the buyers of the trust vehicle would have been eager to see their money directed there. But that's not the main reason they are facing significant losses.

The coal company's vice-chairman was arrested in 2012 for taking deposits without a banking licence. And it turned out that Zhenfu had borrowed billions more at high interest rates from shadow lenders, saddling it with such hefty liabilities that these have impaired its ability to repay the trust loan.

China Credit, which is supposed to make the first payment on the issue at the end of January, is reported to be weighing some compensation, under pressure from the government, which has been trying to reduce the systemic risks posed by shadow banking. The category, which includes the banks' own off-balance-sheet vehicles, trust companies, securities dealers, leasing outfits, insurers, pawnbrokers and other informal sources of capital, accounted for nearly 5.2 trillion yuan in loans last year, a jump of 43 per cent from 2012.

Right now, efforts to corral the shadow market are being stymied by turf conflicts between the People's Bank of China and the industry watchdog, the China Banking Regulatory Commission. The central bank is pushing for tougher rules to restrict bank dealings with the shadow credit sources, which enable the regulated lenders to skirt loan limits and boost profits. Central bank officials regard the CBRC as too protective of the banks' interests. But the regulatory agency counters that there is a risk of triggering a full-blown financial crisis, as well as a funding crunch for businesses as credit becomes scarce, if such a clampdown is too heavy-handed.

The best way to curb the Chinese appetite for high-risk alternatives is to offer more options, provide full disclosure on what investors are buying and carefully explain the dangers in plain language. After that, some heavy losses from lousy loans ought to be enough to cool the ardour of all but the most intrepid gamblers.

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