The explosive growth of shadow banking has raised both intrigue and concern among experts, as it has significantly changed the structure of the global financial system. Since the 2008 financial crash, international regulatory agencies and organizations have been conducting extensive research on the topic. Shadow banking in China has sparked huge debate over its definition, scale and potential off-balance-sheet risks. The China Banking Regulatory Commission (CBRC) has issued Regulatory Document no. 8, concerning off-balance-sheet wealth management products, and Document no. 107 (“Notice of the General Office of the State Council on Enhancing Regulation of Shadow Banking”). Since publication of these documents the focus has shifted from systemic financial risks arising out of the shadow banking system to the division of regulatory responsibilities and the coordination of regulation.
This chapter clarifies the basic concepts, scale and risks of shadow banking in China. It also offers several policy suggestions to tackle regulatory issues.
1.1 Shadow Banking System: Controversy and Evolution
American economist Paul McCulley coined the term shadow banking in 2007. A year later, Timothy Geithner, then president of the Federal Reserve Bank of New York, called it “the parallel banking system.” Shadow banking refers to non-banking financial institutions. Examples include investment banks, private equity funds, money-market mutual funds, mortgage intermediaries, hedge funds, bond insurance companies, and structured investment vehicles.
In 2012, the European Central Bank described shadow banking as a credit intermediary outside the regulated banking system. The popular “originate-to-distribute” model allows the bank to transfer a regulated asset on the balance sheet to an unregulated off-balance sheet. With the widespread application of securitization vehicles, the evasion of relevant regulation is of particular significance.
Scholars are divided when it comes to the definition of shadow banking. The most authoritative description so far comes from the Financial Stability Board (FSB). It provides a broader definition of shadow banks to include all entities outside the regulated banking system that perform credit intermediation. The FSB established four fundamental features of shadow banking: maturity transformation, liquidity transformation, leverage, and credit-risk transfer. The FSB’s definition of shadow banking has gained worldwide recognition. However, since the FSB only follows the Eurozone and 25 other economies, its definition may not apply to all economies and policy frameworks.1
Chinese researchers also have mixed views on the subject. There are three main debates. The first is whether shadow banking is subject to regulation. The second is whether it can cause systemic financial risk. The third looks at whether non-traditional credit financing is different from traditional banking.
Those who agree with the FSB’s definition, according to which China’s shadow banking system only includes private lending and third-party wealth management on an estimated scale of 400 billion USD in 2010, believe it is a common “misunderstanding” to classify financial products and trust products as shadow banking.2 In January 2014, China’s State Council issued a directive called the “Notice of the General Office of the State Council on Enhancing Regulation of Shadow Banking” (Document no. 107). This was regarded in various circles as the first comprehensive definition. The notice clarified three categories of shadow banking. The first are intermediaries who do not have a financial operating license and are not part of the regulation system. Independent financial advisors and Internet finance firms are examples of this. The second are those without licenses who are only partly regulated, such as credit-guarantee companies and small loan firms. The third type are those that have licenses but face inadequate regulation in such areas as money-market funds, securitization, and some wealth management services.
The second debate is around the potential risks of shadow banking. The chief advisor of the China Banking Regulatory Commission, Shen Liantao, believes that macroscopic, structural, and microscopic issues may lead to major financial risks. Research areas include wealth management, trust, and the interbank sector as part of shadow banking.3 Corporate bonds have also been recognized as part of the shadow banking category because of the risk of local debt. This view considers internal financial risks and the potential ripple effect. Some scholars have even classified corporate bonds as shadow banking in view of the risk of local debt (Wang Tao et al. 2012). Therefore, different definitions result in different measurements of the scale of shadow banking, ranging from 3,000–4,000 billion yuan to 36 trillion yuan.4 This topic is particularly concerned with the contagiousness of financial risks and internal relations within the financial system.
The third debate looks at non-traditional credit financing as the core of shadow banking and compares it with credit intermediaries in the traditional banking system. Li, Hu et al. discuss the inevitability and risk of the development of non-traditional credit financing from the financial innovation perspective.5 Though subjection to regulation is not the core criterion for shadow banking under this definition, expounding the shadow banking business and risk follows a similar logic to the FSB’s tracking, estimation, and data gathering in relation to shadow banking6 through other financial intermediaries or non-bank financial intermediation,7 although the scope of non-traditional credit financing is larger than that of non-bank financial intermediation..
The FSB’s definition is the most original and least controversial assessment of the shadow banking system. A single perspective cannot reflect the system as a whole, due to the differences in financial structures across the globe. The FSB’s statistical approach neglects some imperative factors relating to China’s financial products and more importantly, fails to cover major structural issues such as the change of credit intermediaries within China’s banking system.
Document no. 107 is an extension of regulation theory and incorporates financial products within the regulation system. To define shadow banking in regulatory terms does not fully allow for changes of structure and distribution of risks in China’s financial system. The definition pertaining to risks neglects crucial factors and often leads to a generalization of the system.
1.2 China’s Shadow Banking System from the Perspective of Non-Traditional Credit Intermediaries
The features of China’s financial system are different to those of other countries and an analysis of them is important to paint a clear picture of China’s shadow banking system.
1.2.1 Features of China’s Financial System
The overall level of development of finance in China has been relatively slow, lagging behind the real sector. Its particular structure reflects the transition from financial repression in a planned economy to a fully functional financial system in a market economy.
(a)
Non-traditional credit intermediaries have changed China’s banking system. Indirect financing remains the core of banking. Almost all types of non-traditional credit financing are closely related to the banking system, which is usually the main purchaser or main channel of distribution of financial products. This close relationship means that if one financial product is at risk, then it is bound to have a potential impact on the banking system.
(b)
Non-traditional credit services provided by financial institutions are growing rapidly. They are providing large amounts of liquidity buffers for the real economy but also create systemic risk in the financial system.
Policy changes by central banks have led to a decline in the capital support provided by traditional finance for the economic development of society. Non-traditional credit intermediaries have been able to provide financing for investments and economic development by gradually breaching restrictions on financial regulation and credit control. Liquidity risks caused by maturity mismatch (long-term asset vs. short-term debt) of non-traditional credit financing are increasing as the market expands, threatening the stability of the financial system.
(a)
Incompatibility between mixed operations and separate regulation structures
In so far as the current stage of China’s financial industry is concerned, the divided regulation system is effective. Limited resources and experience allow regulators to focus on each specific field of finance, as well as making regulation more efficient, by separating the professions. The growing trend towards mixed operations in the financial industry has caused the boundaries between various financial products to become indistinct, making it difficult for a single regulatory entity to supervise these products. Regulatory agencies have different stances and there is a lack of coordination and cooperation between them. Such differences can easily result in regulatory arbitrages and regulatory vacuums.
(b)
Financial innovation suppressed under strict administrative regulation in the financial market, non-complex and underdeveloped asset securitization, and relatively low leverage
Without highly leveraged operations or complex asset securitization, China’s non-credit financing business depends more on ways of distinguishing off-balance-sheet business from on-balance-sheet business. As a result, domestic non-traditional credit financing basically corresponds to assets and liabilities on the balance sheet. Investments in non-standard assets and highly leveraged operation have been largely restricted since the CBRC issued a large number of regulations. In terms of interbank business, some institutions have a higher leverage ratio than others. However, the single-digit leverage ratio of China’s financial institutions cannot be compared with that in the USA, which can easily reach 20–30 times. China’s asset securitization is not as developed and has not yet acquired the complex structural investment vehicles that decrease the fragility of the system.
Overall, the rapid development of non-traditional credit financing causes systemic risks for the financial system. The dominant position of banking within the financial system also means that the risk will first emerge within the banking system. The existing separate regulation system is not compatible with the objective requirements of the development of mixed operations in the financial industry. Even though securitization products lack regulation, and are highly leveraged and complex in structure, they do not pose obvious problems in China. All these aspects demonstrate the internal coherence of the definition of China’s shadow banking system from the perspective of non-traditional credit financing.
1.2.2 Non-Traditional Credit Financial Products and the Shadow Banking System
Shadow banking is an extremely complex system involving a “tri...