China's Shadow Banking: Bank's Shadow and Traditional Shadow Banking

Focus

Banks' shadow, or money creation by banks beyond traditional loans, plays an important role in China's money-creation process. This poses a number of challenges to monetary policy operations and financial risk management. This paper analyses the money-creation mechanisms of China's shadow banking sector in detail, provides accurate measurements, investigates its effects on financial risk and surveys recent regulations.

Contribution

The analysis highlights the critical role of banks' shadow in creating credit money while hiding the credit risk incurred by banks. The challenges posed to monetary policy regulation and financial risk management are also assessed. First, the paper clarifies the definition of shadow banking in China, decomposing it into banks' shadow and traditional shadow banking. Second, this paper quantifies the scale of shadow banking in China using the deduction approach, with the aim of avoiding miscalculation issues such as double-counting and overestimation. Third, the relationship between shadow banking credit and financial risk is investigated at both the macro and micro levels. Finally, the monetary policy challenges posed by Chinese shadow banking is discussed and the recent trend to tighten regulation surveyed.

Findings

At the macro level, Chinese shadow banking funds are used mainly for local government funding vehicles, enterprises with excess capacity, and real estate developers. Banks' shadow is closely related to the money creation indicator M2, while traditional shadow banking is less relevant, reducing the accuracy of M2 as a policy measure. At the micro level, this paper uses the balance sheet information of 311 banks (including listed and non-listed banks) over the past decade. It finds that, although banks' shadow drives up banks' credit risk, banks have not adequately assessed that risk or taken the appropriate countermeasures. In the future, the key to regulating China's shadow banking system will be to strengthen the regulatory mechanism centred on banks.

Abstract

Banks' shadow, or money creation by banks beyond traditional loans, plays an important role in China's money-creation process, posing a number of challenges to monetary policy operations and financial risk management. This paper analyzes the money-creation mechanisms of China's shadow banking sector in detail, provides accurate measurements, investigates its effects on financial risk, and surveys recent regulation. To strengthen supervision, China's regulators should closely track the evolution of various shadow banking channels, both on- and off-balance sheet. Specific macroprudential regulation tools, such as asset reserves and risk reserves, should be applied separately to banks' shadow and traditional shadow banking.

JEL codes: E44, E51, G28

Keywords: banks' shadow, traditional shadow banking, credit money creation, bank accounting, regulation