Chinese Shadow Banking: Solution or Problem?
Compared to other advanced countries, China’s banking system is more constrained by state controls and favors state-owned entities over the private sector — factors that give shadow banks space to compete with the formal sector. Chinese banks must adhere to regulations from the People’s Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC), which set strict limits on loan-deposit ratios, reserve requirements and lending volumes.
These regulations, along with very high expectations for non-performing loans, make it particularly difficult for private small and medium enterprises (SMEs) to access credit. Further, in comparison to other countries, Chinese companies rely primarily on loans and equity issuance instead of debt financing, making the role of banks all the more critical. When SMEs are forced to turn to shadow banks, they generally seek credit that they are unable to obtain at regulated banks because of lending caps.
As China’s economy has appeared increasingly fragile and the shadow banking industry has grown, concern has centered on the potential implications of a crisis in the sector. Bailouts of trust companies in recent years have caused concern that intervention will encourage risky lending at the same time that the proportion of complex financial instruments in the economy increases.[iii],[iv] However, among academics and analysts, there seems to be agreement that the chances of a shadow banking crisis are relatively low. Further, any crisis in the shadow banking sector would likely not endanger the rest of the financial system because it remains small compared to the formal banking sector and because of low central government debt-to-GDP ratios.
Shadow banking provides important economic benefits by increasing access to capital and reducing its cost. It provides services traditional banks cannot and takes on riskier customers or those in less-favored industries. However, shadow banks lack the safety net and liquidity that traditional banks are required to maintain, creating greater risk of instability. Both the PBOC and the CBRC have tentatively welcomed shadow banks given their critical role in the Chinese economy while recognizing the risks they pose. In response to these concerns, the government has issued guidelines to increase transparency while still acknowledging shadow banking’s important role in the economy. Rather than severely restrict shadow banking, regulators would do well to continue this path of measured steps that mitigate the risks without eliminating credit lines that are critical to economic growth.
[iv] China Sets Up Fund to Bail Out Troubled Trust Firms. Wall Street Journal. December 12, 2014.