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A wealth product goes wrong; a bank blames a rogue employee. It sounds trivial. But in China, the crisis at lender Hua Xia could be the beginning of a shadow-bank shakeout. The country's $2-trillion (U.S.) off-balance sheet financing channel may not stay off the balance sheet for much longer.

Bank customers have more than doubled their holdings of wealth management products since 2010, according to Fitch Ratings. These short-dated investments typically offer annualized returns of 3 to 4.5 per cent, beating the 3-per-cent return on bank deposits, which is capped by regulators. Defaults are unheard of, and buyers range from pensioners to state-owned enterprises.

Hua Xia is a test of what happens when a product goes wrong. The bank says an employee in its Shanghai branch illegally sold a wealth management product, which Chinese media reported had then failed to repay investors. It's not yet clear which path regulators will take. One option is to force Hua Xia to pay investors back in full, setting a precedent that banks are liable for the products they sell. The alternative is to leave buyers dangling.

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The first option would effectively force $2-trillion of outstanding products – and the associated loans – onto the balance sheets of China's lenders, increasing their assets by around a fifth. That would eat up capital, and push some banks far beyond the maximum loan-to-deposit ratios enforced by regulators.

But leaving buyers to bear losses isn't much better. If they decline to roll over their investments – or demand higher yields – borrowers whose loans have been funded with wealth management products may hit the wall. This could turn into a disorderly run on the shadow banking system.

Ultimately, the best solution is to lift China's deposit cap. If banks could compete for deposits, they would suck cash out of wealth management products and back into bank accounts. Lenders would lose fee income and see margins squeezed, and some shadow borrowers would get into trouble, but the sector would quickly shrink.

Wealth management products aren't evil. But mispricing, and widespread selling to customers who don't really understand the risks, make them dangerous. If Hua Xia proves a turning point, its long-term legacy could be a healthier financial system.

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