What is Shadow Banking in China

Shadow banking is the underground financial activity outside traditional banking systems and regulations. Outside of traditional, regulated banking, the shadow banking system comprises lenders, brokers, and other credit intermediaries. Shadow banking does not accept traditional deposits. To profit, shadow banks act as intermediaries between large borrowers and lenders. They earn from the interest rate spreads and fees for their services. Experts believe that shadow banking comprises 25% to 30% of the global financial system.

Shadow banking is outside the traditional banking realm. So, the risk, liquidity, and capital restrictions are unregulated and not subject to the same boundaries of traditional banks and government banking regulations. Because shadow banking can take larger risks, it is thought to be one of the main catalysts of the 2008 financial crisis.

Due to the financial crisis, traditional banks were put under closer regulatory inspection. Authorities tightened banks, and the banks imposed stricter requirements on loan and credit applicants. As a result, the number of people needing funding grew, and they looked for shadow institutions outside the restriction of banking regulations to get the fund they required.

Examples of shadow banks include:

• Investment banks
• Bond funds
• Special purpose entities
• Finance companies
• Mortgage lenders
• Money market funds
• Insurance/Re-insurance companies

For its supporters, shadow banking is advantageous as it helps reduce the dependency of people and institutions on traditional banks when getting a loan or credit. For them, it acts as an additional source of lending and diversification in the economy's financial system.

Shadow Banking and China

China, the country with the largest population in the world, is also one of the countries with the largest shadow banking industries. Data show that almost 40% of China’s outstanding loan is tied up in shadow banking activities.

Shadow banking is believed to emerge in China in the late 1990s. However, the patronage to shadow banking in China grew during the 2007-2008 Global Financial Crisis. During this time, traditional banks in China failed to meet the soaring demand for funding because of tight regulations on lending. Some of the other reasons Chinese individuals and companies engage in shadow banking are:

• Insufficient supply of credit from the major banks
• Limitations imposed on risky loans
• Failure of regulators to limit the capacity for regulatory arbitrage
• Control of the Chinese government over interest rates
• Interbank interactions exclusion from credit management

Pushing Shadow Banks Out of the Market in China

The Chinese government has continued to regulate shadow banking in China. Shadow banking has increased predatory loans in the country, putting the economy at risk with high levels of credit risk. Shadow banking crackdown in China helps cut down the interest rates they charge customers, protecting individuals and small businesses from these unregulated financial institutions.

As of June 11, 2022, the China Banking and Insurance Regulatory Commission (CBIRC) banned banks and wealth management companies from using money raised by cash wealth management products or cash WMPs when investing in stocks, convertible bonds, low–rated corporate bonds, and asset-backed securities. These cash WMPs will be subjected to a maximum leverage ratio of 120%. Moreover, financial institutions are required to do a stress test and invest at least 5% of the net value of their cash WMP funds in low-risk assets such as central bank bills and government bonds.

As a result of these rules, the sector has reduced by more than 29 trillion yuan or 4.3 trillion USD by the end of June 2022, said Liang Tao, the vice chairman of China Banking and Insurance Regulatory Commission.

However, the crackdown on shadow banking in China may still go a long way. The still-recovering economy of the country is putting pressure on businesses and individuals. In reality, SMEs have found it increasingly difficult to get their loans approved from traditional banks because of the institutions' favouritism towards large and state-owned enterprises. Thus, they are more likely to resort to shadow banking for lending and other illegal loans to avoid the hassle and get the needed funding to thrive.

With this reality in mind, if SMEs are genuinely considered a pillar in generating a more inclusive and domestic-focused economy in China, authorities should rethink their policies toward shadow banking.

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