Shadow loans and regulatory arbitrage: evidence from China

Summary

Focus

We investigate how far Chinese banks have managed to hide from regulators the risks associated with shadow loans on their balance sheets. We also consider if the financial market in China has priced in risks associated with such shadow loans. In particular, we ask if banks relying heavily on shadow lending have managed to keep funding costs from rising, and if investors in equity and bond markets have required higher returns for more vulnerable banks.

Contribution

Many recent papers have looked at the impact of China's shadow banking sector on financial stability and the real economy. However, they do not explore whether the financial market has priced in banks' hidden risks. This paper uses on-balance sheet shadow loan data for all major Chinese banks to test if individual banks were able to successfully window-dress their financial health. It also uses reverse stress-testing techniques to calculate a break-even non-performing loan (NPL) ratio incorporating shadow loans.

Findings

We find that the ratio of a bank's shadow loans to its net worth correlates negatively with its leverage ratio, but not with its risk-weighted capital ratio. This suggests that banks have managed to window-dress their regulatory capital ratios by using shadow loans. Nevertheless, financial market participants are aware of banks' vulnerabilities to shadow lending. In particular, banks with higher shadow loan ratios or lower break-even NPL ratios face higher wholesale funding costs. Their equity and bond returns are also lower after the announcement of a rare bank failure.

Abstract

This paper examines how Chinese banks used on-balance sheet shadow loans for regulatory arbitrage and whether the financial market priced in the banks' use of shadow loans and the resulting vulnerabilities in 2016–2020. It finds that banks chose to window-dress their regulatory capital ratio by using shadow loans. It also shows that banks with a higher shadow loan ratio or a lower break-even non-performing loan ratio obtained from reverse stress testing faced higher wholesale funding costs. Finally, after the announcement of a rare bank failure event, more vulnerable banks witnessed lower cumulative stock and bond returns.

JEL classification: G12, G14, G21, G28.

Keywords: bank capital regulation, Chinese economy, regulatory arbitrage, shadow banking, reverse stress test.