BIS published a working paper that analyzes money creation mechanisms of shadow banking tools in China, investigates their effects on financial risk, and surveys recent regulation. Using the balance-sheet information of 311 listed and non-listed banks from over a decade, the paper investigates the relationship between shadow banking credit and financial risks at both the macro and micro levels. It summarizes the shadow banking regulations implemented by Chinese regulators, discusses the related issues, and sets out policy implications. The paper also highlights the critical role of banks’ shadow in creating credit money and hiding the credit risk incurred by banks.
Regulatory arbitrage is believed to be a key driver for the emergence of shadow banking worldwide. The case of China is similar but more complex, given China’s unique banking regulations, such as regulated deposit and lending rates in addition to certain lending restrictions. Recent studies have focused on shadow banking as a unique feature of the financial system in China. Appendix B of the paper provides a list of shadow banking related regulations that have been announced or implemented by the authorities such as PBC, CBIRC, and CSRC. The main regulator of Chinese shadow banking is CBIRC, which coincides with the reality that Chinese shadow banking centers on banks rather than on traditional shadow banking, which channels funds through other types of financial institutions.
The paper clarifies the definition of shadow banking in China, decomposing it into banks' shadow and traditional shadow banking. It finds that, although banks' shadow drives up the credit risk of banks, banks have not adequately assessed that risk or taken the appropriate countermeasures. Banks' shadow impairs the effectiveness of banking regulations aimed at lending and leads to the accumulation of systemic risk. A resulting policy implication indicates that regulators should apply different restrictions to banks’ shadow and traditional shadow banking and focus on the balance-sheet items that banks may use to hide their shadow banking operations.
The paper proposes policy implications for both the traditional and shadow banking systems. First, appropriate regulation should be applied to the traditional banking system. To avoid an accumulation of shadow banking risk, regulators should avoid applying overly strict traditional policies to traditional banks. and should balance the pros and cons of the shadow banking system. Regulators may need to take measures to protect “shadow funds.” In terms of how to regulate shadow banking more effectively, guidance on general regulation and specific regulatory measures are critical. Current suggestions for regulation guidance include macro-prudential and countercyclical regulation in the Basel III framework, in addition to the functional and category-based regulation.
The paper concludes that, to strengthen supervision, regulators in China should closely track the evolution of various shadow banking channels, both on- and off-balance sheet. Specific macro-prudential regulation tools, such as asset reserves and risk reserves, should be applied separately to banks’ shadow and traditional shadow banking. In the future, the key to regulating the shadow banking system in China will be to strengthen the regulatory mechanism centered on banks. Both banks’ shadow and traditional shadow banking are intricately linked with the banking system and they draw on banks as the main funding source. The regulatory authorities should seek to enhance their macro-prudential management of the banking system to preempt future excessive growth of financial risks.
Related Link: Working Paper
Keywords: Asia Pacific, China, Banking, Shadow Banking, Credit Risk, Research, Market Based Finance, Macro-prudential Policy, Systemic Risk, BIS
Across 35 years in banking, Blake has gained deep insights into the inner working of this sector. Over the last two decades, Blake has been an Operating Committee member, leading teams and executing strategies in Credit and Enterprise Risk as well as Line of Business. His focus over this time has been primarily Commercial/Corporate with particular emphasis on CRE. Blake has spent most of his career with large and mid-size banks. Blake joined Moody’s Analytics in 2021 after leading the transformation of the credit approval and reporting process at a $25 billion bank.
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