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Regulating shadow banking - China's perspective

On 24 May 2017, the Hazelhoff Centre for Financial Law welcomed Shen Wei, Dean and Professor of law at Shandong University School of Law in China, for the 14th Hazelhoff Guest Lecture.

Shen Wei
24 May 2017

According to the Financial Stability Board (FSB) shadow banking can be defined as a system of credit intermediation involving entities and activities outside the regulatory and supervisory sphere. China has a significant shadow banking sector, approximately 45% of China’s gross domestic product (GDP), involving a variety of banking like activities. The three main credit rating agencies, namely Moody’s, Standard & Poor’s and Fitch, recently published information regarding China’s shadow banking sector, highlighting the potential systemic risk and stability implications regarding China’s financial markets and real economy. But what is the success of the Chinese shadow banking sector and what is the response of the Chinese government to it? Furthermore, what challenges lie ahead for the regulator? In this Hazelhoff Guest Lecture, Professor Shen Wei discussed, among other things, these questions and gave a comprehensive overview of the shadow banking sector in China.

Shadow Banking: An overview

During the first part of this lecture, Professor Wei explained the myth of Chinese bank’s success and shadow banking. While their counterparts were suffering during the recent financial crisis, Chinese banks appeared to be outside the turmoil. The Chinese government, for instance, adopted a huge legislative package that reformed the regulatory regime long before the United States did. As a result, banks are heavily regulated. Nowadays, major Chinese lenders are at the top of global rankings by market capitalization and are among the most profitable in the world. Nevertheless, Chinese banks are also encountering serious problems, such as policy oriented lending initiated by the government and other lending irregularities, for instance, the increase of non-performing loans.

According to Professor Wei these developments go hand in hand with the growing shadow banking sector. The shadow banking sector and the regular banking sector are highly interconnected. As a result of the strict regulation, banks have to comply with restriction in extending loans. On the other hand companies face problems in managing their liquidity and are not always able and competent  to lend money from traditional banks and therefore seek another route through non-bank entities. By doing so shadow banking entities replace the function of financial intermediation, which is traditionally a core element of a bank’s business, but simultaneously contribute to the continuance of the Chinese economy. Despite of the growing significance of the shadow banking sector, traditional banks cannot (yet) be disregarded. The close interconnectedness between shadow and regular banking creates a potential spillover effect – the consequences of failing institutions can spill over to other parts of the market and cause severe systemic financial disruption. Because these sectors are so interconnected, the regulator faces complex issues in mitigating systemic risk. Furthermore, the regulator focuses mainly on the regular banking sector, by which the aforementioned issue becomes even more complex to tackle. The Chinese government, unlike other countries, appears to admit the importance of the shadow banking sector for the funding of SME’s and other parties that are restricted from normal bank loans. In 2013 the Chinese State Council launched an internal document, better known as Circular Relating to the Issues on Shadow Banking Regulation (Circular 107). Although this document does not include a clear definition of shadow banking, it identifies three types of shadow banking activities. Furthermore it recognizes the functions of shadow banking to the traditional banking sector and, which is of paramount importance, warns of the systemic risks associated with shadow banking. 

Unique features of the Chinese shadow banking market

Throughout the second part of the lecture, Professor Wei discussed several components and features of the Chinese shadow banking sector. First, he mentioned that the Chinese shadow banking sector is characterized by its simplified approach. Complex structured financial products, such as derivatives, commercial papers and asset-backed securities are less common than in other financial markets. The major form of shadow banking activities in China is direct provision of credit, such as peer-to-peer lending platforms and the underground lending market. As already noted by Professor Wei, the regular and shadow banking market are deeply interconnected and therefore banks are not excluded from shadow banking activities. The participation of banks in shadow banking activities is actually inevitable, given the predominant position of banks in the lending market. As a result, wealth management products and local government financing vehicles can also be added to the definition of shadow banking in China. Both financial products rely on loans of regular banks but lend money outside the formal banking system. Regulators, not only in China, face an enormous challenge in regulating the shadow banking sector. Policymakers have to prioritize risk prevention and continuously stress the importance of financial innovation, which can be established by shadow banking; eventually this will contribute to a healthy, efficient and sophisticated capital markets in China.

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