China’s shadow banking sector has grown rapidly in the last decade. While bank loans still dominate the financial system as a main source of funding, the shadow banking sector reached 32.9 percent of total social financing by 2016, though it then fell to 24.2% percent by 2019. Households and corporations benefit from the growing shadow banking sector as an alternative funding source; however, it presents concerns to regulators who are charged with maintaining the stability of the financial system. In our recent paper, we suggest that the implicit guarantees from nonbanks, banks, or government to the shadow banking sector might provide a second-best arrangement in funding risky projects in the real economy and improving welfare, without amplifying systemic risks.
The rise of China’s shadow banking and its components
Shadow banking is broadly defined as credit intermediation that occurs through activities and entities outside the regulated financial system. Therefore, shadow banking is lightly regulated. Shadow banking exhibits some different features depending on the region. For example, in the US, before the outbreak of the Subprime Crisis in 2007, shadow banking provided sources of funding to real estate by converting opaque, risky, and long-term assets into short-term liabilities with perceived lower risks. The heavy reliance on short-term liabilities to fund illiquid long-term assets made the financial system more fragile and prone to runs. In the Euro Area, the shadow banking sector is dominated by securitization activities, money market funds, and hedge funds. In China, shadow banking is more bank-centric, and smaller banks engage more in issuing off-balance sheet products as a response to regulatory and credit constraints.
In China, the components of shadow banking include the issuance, by a variety of institutions, of wealth management products (WMPs), asset management products (AMPs), entrusted loans, trust loans, undiscounted bankers’ acceptance, loans by finance companies, microcredit, peer-to-peer (P2P) lending, and informal lending. Entities involved in shadow banking are trust companies, broker dealers (securities companies), and P2P platforms.
The upsurge of China’s shadow banking is driven by liquidity regulation in the banking system, the Stimulus Plan launched at the end of 2008, as well as credit constraints in certain industries, especially the real estate industry. On the bank side, there were strict regulatory ceilings on both deposit rates and loan-to-deposit ratios (LDR). Hence, to circumvent regulations, banks have strong incentives to issue WMPs, as WMPs and the assets they invest in are not consolidated on the banks’ balance sheets. Instead, the funds can be funneled through mechanisms including trust loans, various types of beneficiary rights, and accounts receivables. Meanwhile, the RMB four-trillion Fiscal Stimulus Plan announced in 2008 further triggered the high financing demand in certain industries including real estate. However, the People’s Bank of China (PBoC) – China’s central bank – imposed loan quotas on commercial banks in real estate and industries with over-capacity through administrative window guidance, which the PBoC uses to manage the pace of credit provision (Allen et al., 2017). The large ensuing gap between the financing demand and bank loans in these areas propelled the rise of the shadow banking sector. Indeed, existing evidence (Allen et al., 2019; Allen et al. 2020) has shown that the majority of funds raised through entrusted loans and trusted products have flowed to the real estate and infrastructure industries.
Pricing, risks, and implicit guarantees
Recent studies have suggested that initial pricing of shadow banking products (entrusted loans and trust products) has reflected the fundamental risks as well as informational risks of the underlying borrowers. For example, the lending rates of entrusted loans increase if the borrower is in a high-risk industry, while rates decrease if it is a state-owned enterprise (SOE) or if the borrower and lender are in the same industry or located in the same city. The ex-post probability of default also increases with the lending rates. Further evidence indicates that while the borrowers of entrusted loans are on average riskier, the aggregate risk is mitigated because the lenders of entrusted loans are better capitalized than banks. From this perspective, the existence of shadow banking to channel funds to riskier industries can in fact reduce the likelihood of risk transmission from these riskier industries to the standard banking system, and further reduce systemic risks (Allen et al., 2019).
On the other hand, the higher riskiness of shadow bank borrowers makes implicit guarantees from either banks, nonbanks, or the government attractive to investors. Such implicit guarantees in an environment with systemic and idiosyncratic risks can be the “second-best” arrangement in funding risky projects. Moreover, the implicit guarantees also flatten the sensitivity of yield spreads to the risks of the borrowers (Allen et al., 2020).
The structure of shadow banking and the involvement of financial institutions are unique in China. The existence of this sector fulfills the high demand for financing. While it may bring some risks to financial stability, it may not be desirable for regulators to entirely eliminate these risks. Implicit guarantees from banks, nonbanks, or the government may provide a second-best arrangement in funding risky projects and improving welfare in China.
Franklin Allen is Professor of Finance and Economics and Director of the Brevan Howard Centre at Imperial College London
Xian Gu is an Associate Professor at Durham University.
This post is adapted from their paper, “Shadow Banking in China Compared to Other Countries,” available on SSRN.
 The latest version of this paper is: Allen, F., X. Gu, W. Li, J. Qian, and Y. Qian, 2020. Implicit Guarantees and the Rise of Shadow Banking: the Case of Trust Products. Imperial College London Working Paper.