The Chinese Economy: Regulation vs. Shadow Banking

Shadow banking is on the rise in China.

China Beige Book, which studies independent data on the Chinese economy, recently reported a significant increase in the phenomenon, accompanied by the intertwined issues of slowing economic growth and high levels of debt.

Given the inherently fragile nature of shadow banking and the importance of the Chinese economy to the global economy, the rise bears examination.

So what’s happening?

THE FUNDAMENTALS ARE THE SAME

At its core, China’s financial system isn’t different from that of the U.S. or other Western nations.

“The Chinese banking system acts with the same profit-maximizing motive as do the Western banks,” says Kinda Hachem, a professor in the Global Economies and Markets area at Darden and author of “Shadow Banking in China,” which appeared in the Annual Review of Financial Economics. “It isn’t exactly the same system as the U.S. economy, but it is competitive.”

In both the U.S. and China, financial rules incentivize some lenders to work outside the conventional, regulated banking system. Banks can more easily raise funds, thereby increasing their lending activity, by venturing into shadow banking — the borrowing and lending activities that happen outside standard regulatory rules.

“Shadow banking will always be pursued by the institutions most constrained by the banking regulations,” says Hachem. It stands to reason; financial institutions want to increase their profits without running afoul of the rules.

While the shadow banking sector is alive and well in both the U.S. and China, the way things have played out has a major difference: In the U.S., larger banks felt the constraint of regulation, while in China, it was the smaller banks.

But stay tuned. Small banks don’t mean small impact.

LENDING AND CONTROL

In the first place, smaller Chinese banks “have a higher marginal propensity to lend,” as Hachem’s paper notes, and lend a far more significant portion of their funds than do larger Chinese banks. Smaller banks typically lend around 85 percent of their deposits, compared to approximately 60 percent by larger banks, the research shows.

Things get interesting when the Chinese government decides to tighten control of lending. The government may make such a decision when the economy looks like it’s overheating and may cause inflation to rise too rapidly.

Banks are required to have a minimum percentage of liquid assets, like cash, on hand at all times. When the China Banking Regulatory Commission enforces liquidity requirements, it creates a binding constraint on the activities of the smaller banks.

As a result, these smaller banks offer individual investors unguaranteed “wealth management products” (WMPs). WMPs typically have a high rate of interest and short-term maturities and, importantly, can stay off the bank’s balance sheet if not explicitly guaranteed — therefore not subject to regulation.

The smaller banks quickly attract new deposits via their shadow banking WMPs, which offer far better interest than the deposit rates available at the larger banks. They will “poach deposits away from the larger banks while moving into shadow banking,” the report states.

As investors and their capital move from the bigger banks, with their low propensity to lend, to the smaller banks, with their higher propensity to lend, the result is diametric to tighter government control and lower borrowing from individual investors: “The rise in shadow lending more than offsets the net fall in traditional lending, implying an increase in total credit,” the report states.

Ultimately, the heavier constraints felt by smaller banks have far-reaching implications for Chinese regulators. And if government attempts to constrain lending do the opposite of their intent, the government’s lost a battle in the effort to fight an overheating economy.

Kinda Hachem authored “Shadow Banking in China,” which appeared in the Annual Review of Financial Economics.

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