The issue of the shadow banking system in China has put the country on the hot seat and there has been no shortage of opinions coming from various segments of the financial market including of the ratings agencies. The negative perception around the system has grown tremendously and rightly so and some in the market believe the situation now resembles more or less like a wild west and the regulators seem to have very little handle on the sector so there is an urgent need for the policy makers to take proactive steps to reform the existing system.

The authorities including of the officials at the People’s Bank of China ( PBOC ) and the Chinese premier Mr Li Keqiang finally seem to be taking a tough line and have made their intentions quite clear to the market as evident from their recent statements. Also by not reacting to the liquidity squeeze felt by most local banks in the first two weeks of June which pushed the short-term interbank and money market rates to an uncomfortable level hindering banks business the policy makers took a huge risk by refusing to inject cash into the system. Through their action the authorities in China have shown that they are serious about reforming and restructuring the economy and also willing to rein on uncontrolled credit growth by punishing speculators and the shadow banking system.

This is certainly a step in the right direction but not sufficient. The reform agenda will also require the policy makers to look inwards and assess the overall affect of the existing policies. I am starting to wonder if the annual lending quota or limit set by the policy makers at PBOC infact encourages the growth of shadow banking system in the country as most of the local banks lending done under the existing quota system goes to the state owned companies leaving the small and medium size privately held companies to chase very expensive alternative source of capital. Also since the banks aren’t generally able to provide decent return on saving accounts to depositors so a significant percentage of the savers money ends up in the shadow system chasing high returns.

 The shadow banking system in China has been growing at over 34% annually since 09 and is estimated to be worth over US 5 trillion dollars today which is approximately around 58% of the country’s GDP and makes up about 32% of the total banking assets. The size of the system is clearly huge and there is a clear emerging evidence that links the growth of the shadow banking system to the existing regulatory environment. So a reform of the system is badly needed and the reality is that the shadow banking system isn’t going to go away tomorrow even if the policy makers were to carry out a wholesale reform of the system and it isn’t just a Chinese problem.

The shadow banking system isn’t a new phenomenon or trend it has coexisted with the traditional banking system around the world for decades and according to the financial stability board (FSB) latest estimates the global shadow banking assets crossed over the US$ 67 trillion mark in the financial year ending 2011. The existing system has inherent risk and serious vulnerabilities and it is also a significant systemic risk threat to the overall financial system.

Having said that while addressing the regulatory oversight concerns it is important for policy makers to recognise that the existence of a shadow banking system in a country isn’t all negative for the economy. The sector does play an important role in the overall financial system by providing liquidity, risk transfer, access to alternative source of capital, it is also a very adaptive system with tremendous ability to reinvent itself and a good indicator of the overall economic activity among other things. So there are clear visible benefits of the shadow banking system to the economy.

A good and workable solution will require the policy makers at the People’s Bank of China ( PBOC ) along with the government to have a proactive and flexible approach when setting the reform agenda for the shadow banking system in the country. Their aim should be on facilitating the right incentives to make sure the sector works better by adding real value and serves as an important complimentary building block to help create a better and sustainable financial system vital for the overall well-being of the country.

1 Comment

  1. Hi – I think it’s better to qualify what’s shadow banking. Is it simply non bank financing? I think the critical word here is “shadow” which conjures the image that these are businesses un-monitored, much less regulated. Then the second word “banking” gives the impression that these institutions both take deposits and provide loans – the two basic functions of a bank. Why does a system need to have both? What would help eventually is just to have borrowers and lenders meet directly in the market place, with brokers acting as intermediaries who do not actually take any deposits nor making any loans. Then you can debate whether to institutionalize something like the Glass-Steagall act. Otherwise, in my view “shadow banking” is really a transition for developing economy to spawn into a proper capital market to complement traditional banking. There is no need to support shadow banking – it should be phased out.


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