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305
Regulatory responses to the Chinese shadow banking development
Jagiellonian Journal of Management
vol. 1 (2015), no. 4, pp. 305–317
doi:10.4467/2450114XJJM.15.021.4830
www.ejournals.eu/jjm
Regulatory responses to the Chinese shadow
banking development
Piotr Łasak1
The Jagiellonian University in Kraków, Institute of Economics, Finance and Management
Abstract
Shadow banking systems were developing rapidly in the Western economies during the last
two decades. Research from recent years show that within the last years equally important
process of shadow banking development occurs in some emerging markets, and among oth-
ers, in China. e system was not only a sophisticated part of China’s nancial market, but
played very important role in the development of the Chinese economy. e aim of this arti-
cle is a description of the mechanisms of shadow banking development in China, character-
istics of the main threats of this system and the regulatory approach in the country. Despite
many threats, the shadow banking system plays an important role in the Chinese econo-
my. ere is a need for its regulation and support for further development.
Paper type: review article
Keywords: Chinese nancial market, shadow banking, trust companies, wealth manage-
ment products
Introduction
Shadow banking is evolving mainly in developed countries. e Financial Stabili-
ty Board estimates that in 2014 more than 80% of global shadow banking assets re-
side in advanced economies (FSB Financial Stability Board, 2015, p. 2). Despite that
there are several countries classied as an emerging economy or developing coun-
try, where the system is growing very rapidly. Among them is China. e country
1 piotr.lasak@uj.edu.pl
306
Piotr Łasak
belongs to 26 jurisdictions which the FSB is monitoring the development of shad-
ow banking and treating the sector as an important part of country’s nancial mar-
ket. China is the leading emerging country where shadow banking is developing
rapidly. Actually the Chinese share of global shadow banking assets is 8% (the end
of 2014) and it is very rapidly developing (in the 2010 it was only 2% of the glob-
al shadow banking) (Canuto, 2015). e article concerns the issue of the Chinese
shadow banking development and the regulatory responses to the threats stem-
ming from the system. e main motive was to synthesize the issues and assess the
introduced regulatory changes.
1. The importance and characteristics of Chinese shadow
banking
e shadow banking in China is similarly dened as in another countries. e Peo-
ple’s Bank of China denes it as “a credit intermediation involving entities and ac-
tivities outside the regular banking system, that provides liquidity and credit trans-
formation” (Elliot, Kroeber, & Qiao, 2015, p. 4). e system in China diers from
shadow banking in another countries in its structure (Table 1).
Table 1 The comparison between shadow banking in China and in Western countries
China’s shadow banking Western shadow banking
Domestic nancial system Both domestic and foreign nancial system
Mainly driven by commercial banks Mainly driven by non-bank nancial institutions
Underdeveloped secondary market Well-developed secondary market
Low securitization rate High securitization rate
Low leverage rate High leverage rate
Purchases made by individual investors Purchases made by institutional investors
Immature development phase with inherent risks More mature development phase
Irregular fund raising and lending operations More regular fund raising and lending operations
Source: van der Linden, 2015, pp. 111–114.
By contrast to Western economies, where shadow banking refers to an invest-
ment management scheme on the nancial market, China’s shadow banking is
playing an active role in broadening investment channels to the private sector. e
Chinese shadow banking consists of less complex nancial instruments. e system
is shallow, does not have any protection from the state, and is quite underdeveloped
307
Regulatory responses to the Chinese shadow banking development
in the institutional side. e other important feature of the system is that it is more
strictly interconnected to the traditional banking than shadow banking systems in
other countries. Comparison to the shadow banking in the United States and China
shows that the Chinese system is based on implicit guarantees and is bank oriented,
whereas the American system is based on nancial engineering and is oriented on
capital market (Van der Linden, 2015; Elliot et al., 2015; Dang, Wang, & Yao, 2014).
In the Chinese model it resembles straightforward lending. It allows to develop
lending activity and to bypass the regulations imposed on the operations. In the lit-
erature are enumerated three major groups of shadow banking entities:
– banks with their Wealth Management Products (WMP),
– non bank nancial institutions, e.g. trusts, brokers, insurance companies,
security funds and leasing companies,
– nancial intermediaries for small businesses and underprivileged consum-
ers (Zhang, 2014, pp. VII–VIII).
Strong regulations for banks and very low ocial rates of interests have led
banks for searching alternative ways of investments. One of the best alternatives to
traditional products oered by banks in China are WMP. ey are products created
by trust companies – intermediaries which are not allowed by law to accept depos-
its or lend out money, but they are allowed to manage them. Trust companies use
traditional banks as their agents and by this way collected money and invest them
in market companies and dierent enterprises. Banks connected with trust com-
panies roll out loans o balance sheet into trust products, which banks then resold
to retail customers. WMP provide returns based on the performance of a pool of
underlying assets. Some of the investments are typical credit like investments, but
other are more speculative products, oriented on dierent risky issues like spirits,
graveyards or even more imaginative investments. e high risk inclined in such
products are cushioned by collateral and downgraded by leverage (e credit cu-
lacs, 2013). WMPs play signicant role in the Chinese nancial system – together
with trust products they represent over 50% of China’s GDP and create the shadow
banking system in China (Sekine, 2015).
Apart from the traditional banks, Chinese shadow banking includes also non-
bank institutions, like micronance companies, guarantee companies, leasing enti-
ties and some other similar institutions. eir aim is to help encourage credit access
for small and rural borrowers (Elliot et al., 2015). Signicant role in Chinese shad-
ow banking play trust companies and created by the companies Trust Products.2
Trust companies are a special institutions that engage in the nancial intermedia-
tion that the traditional banking sector and capital market cannot fulll. ey are
able to invest in the money market businesses, capital market businesses, and al-
2 Trust Products are nancial transactions undertaken and managed by trust companies.
308
Piotr Łasak
ternative investments. During last few years trust companies invested in China in
selected industries, like: manufacturing, energy transportation and construction,
mining, electricity, gas and water production, wholesale and retail, soware and IT
services and real estate sector (Sheng & Soon, 2015).
Table 2 Comparison between Wealth Management Products and Trust Products – the main
components of Chinese shadow banking
Wealth Management Products Trust Products
e main
creating
institutions
WMPs are typically structured and
sold by banks as savings products but
are recorded o banks’ balance sheets,
and hence, not subject to the deposit
regulation.
Trust products are structured by non-bank
nancial institutions like trusts, brokers, in-
surance companies, and security rms. ese
entities typically need to cooperate with banks
in reaching out to individuals or corporate
savers.
Investment
goals
Invested mainly in interbank lending
and interbank bond markets.
Funds raised by trust products are channeled
to riskier borrowers (e.g. property develop-
ers, mining companies and local government
nancing vehicles) as trust loans.
Growth China’s WMP have grown rapidly,
from less than ¥500 billion in 2004 to
¥9.5 trillion by the end of 2013.
Trust industry became the second largest
subsector of China’s nancial system in 2012,
with total assets of ¥7.47 trillion, up from
¥1.24 trillion in 2008. e total assets of the
trust sector were ¥12.48 trillion by June 2014.
Source: based on Dang et al., 2014; Liansheng, 2015.
e last group of Chinese shadow banking entities is formed by non-bank
nan cial intermediaries, which activity is oriented on the small businesses and in-
dividual consumers. Among such institutions are: micro lenders, pawn shoppers
and the underground black market (Dang et al., 2015).
2. The reasons of development shadow banking in China
during 2005–2015
Shadow banking in China is developing very quickly, especially aer the nancial
crisis of 2007–2009. It is estimated that the annual growth of non-nancial inter-
mediaries in China in the period 2010–2012 was growing at a rate of 34% per year
(Labes, 2013). e system started to develop at the end of 1990s, but its rapid de-
velopment and the increase in coverage occurred in the last few years. It is reect-
ed by the statistical data on the size and composition of shadow banking in Chi-
na (Table 3).
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Regulatory responses to the Chinese shadow banking development
Table 3 Size and composition of China’s shadow banking (in RMB 1 bilion)
Ye a r Entrusted
loans
Trusted
loans
Bankers’
acceptan-
ces
Interbank
entrusted
loan
payments
Financial
leasing
Small loan
companies
Total
2002 267 0 256 523
2003 328 0 457 784
2004 639 0 428 1067
2005 836 0 430 1266
2006 1105 172 580 444 2212
2007 1442 342 1250 558 3503
2008 1868 657 1357 738 4530
2009 2546 1093 1818 628 5995
2010 3421 1480 4152 1680 270 198 11111
2011 4717 1683 5179 1872 426 391 14180
2012 6001 2972 6229 2894 608 592 19207
2013 8551 4812 7004 3000 766 819 24952
Source: Elliot et al., 2015, p. 10.
e Chinese credit system is dominated by banks. ey are the main credit sup-
plies in the country. e other sectors of the Chinese nancial market are under-
developed and businesses cannot treat them as an important source of nancing.
e data concerning 2012 states that banks provide the private sector with credit
amounting to 128% of GDP, whereas the bond market provides credit equivalent
to 41% of GDP and the stock market capitalization was about 44% of GDP (Elliot
&Yan, 2013, p. 7). Despite rapid growth of the Chinese stock market during the last
years, much of securities purchases are made by banks what means that it is di-
cult to diversify the nancing source. Among the main features indicating the dom-
inance of banking sector are:
– the legal position of banks in the country (they are mainly state owned and
state controlled),
– the state protection for banks against competition and implicit guarantees,
– the prudential regulations concerning lending activities which determine
the privileged position of banks (Elliot et al., 2015).
e position of traditional banking sector determines shadow banking devel-
opment in the country. Shadow banking in China is acting as a substitute for -
nancing within the formal nancial system. Its development is caused by a desire to
circumvent the existing regulatory impediments. e banking sector did not pro-
310
Piotr Łasak
vide nancing for businesses in the level as it is needed in the fast growing econo-
my. is situation is caused by the number of regulations imposed on bank lending
(e.g. the limits of bank loans to deposits, discouragements on lending to certain in-
dustries, caps on bank lending volumes imposed by the central bank, etc.). e lim-
ited credit availability is particularly severe for small and medium-sized enterpris-
es, which started to searching alternative ways of nancing. e opportunities for
savings and other forms of investment for the commonage and the small business-
es are also limited (Allison, 2015). In order to circumvent the regulatory measures
banks have started cooperation with shadow banks.
An important factor, which led to the development of Chinese shadow banking
were the interest rates in the country. e interest rates are being strictly controlled
by the Chinese government (e.g. by the deposit rate ceiling), what led to the situation
when real interest rates were either close to zero or negative. e aim of the policy
was to articially reduce the relative price of capital, especially for selected branch-
es of industry. Commercial banks were trying to evade the regulatory restrictions on
deposit rate and interest rate. e maximum interest rate allowed by the regulations
was 3.3%. e very low or close-to-zero interest rates resulted with withdrawal de-
posits from banks and search for new, higher-yielding investments. Banks were try-
ing to limit the deposit outows by increasing household investments return and to
provide higher level of nancing to the private sector. To achieve this they started
to operate in the shadow banking system. In accordance with the law the big state-
owned enterprises had an easy access to cheap bank credit, while more ecient pri-
vate enterprises were struggling for nancing. e development of shadow bank-
ing allowed such private-owned enterprises better access for capital (Wang, Wang,
Wang, & Zhou, 2015). It had a positive impact on the entire economy. e system
helped to fuel the Chinese economic growth by making nancial services widely
available to a larger group of the country’s population at a cheaper price.
In the Chinese system banks were not able to give loans for unsecured compa-
nies, like real estate developers or coal miners. Such enterprises were forced to pay
high rate of interest, but the banks had to give loans to the state-owned enterprises
rstly, and had a short of capital to nance the more risky enterprises. On the oth-
er hand they were motivated to give loans to private enterprises, which guaranteed
higher return. In order to collect necessary deposits they set up WMPs, and oered
them via a trust companies to keep the transactions o the bank’s books. By the way
they were able to oer loans to the private enterprises. e interbank rates connect-
ed with the o-balance transactions were higher than the ocial rates. Due to the
fact banks were able to collect very easily additional deposits when ocial interest
rates were kept at the very low level, and many individual investors were looking for
favorable investment opportunities.
e crisis that began in 2007 in the United States also moved to China. It caused
a decline in the FDI inow and export decrease. In response, the Chinese govern-
ment has prepared a stimulus package for Chinese economy, amounting to 586 bil-
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Regulatory responses to the Chinese shadow banking development
lion USD. e money not only boosted the real economy, but also strengthened the
Chinese nancial market, opened various channels of nancing investments and
resulted in the development of shadow banking. e system was considered as nec-
essary for the development of Chinese economy. Non-bank shadow banking chan-
nels have a number of key advantages over the traditional banking, which were
hampered by the rigid rules. It has grown very rapidly aer the nancial crisis and
enlarged its share (Figure 1).
Figure 1. Chinese shadow banking system, as a percentage of GDP during 2004−2014.
Source: Bloomberg and CEIC in Dang et al., 2015, p. 28.
e Figure 1 shows that aer the nancial crisis the total credit level increased
its share in relation to the bank loans. It was a consequence of the policy adopted
in response to the crisis.
3. Crisis on the horizon
e functioning of shadow banking in China, like in other countries, is associated
with high risk. It is due to the fact that the system is unregulated and is not protected
by a lender of last resort. Among the main threats are risks of liquidity and solven-
cy, moral hazard, interconnectedness between shadow banking entities and regular
banking system, and the most important which comes from the nature of shadow
banking – the systemic risk.
312
Piotr Łasak
Some economists argue, that Chinese shadow banking is associated with low-
er risk in comparison to other countries, because its constituent institutions do not
use aggressive strategies such as hedge funds, investment funds and other such en-
tities and they do not use so high leverages as are being used in foreign shadow
banking systems. ey are less involved in the securitization process and do not use
instruments like derivatives, CDOs, CDS, etc. and such long chain of nancial in-
termediation as in some other countries are nonexistent.
e counterargument is that products like WMPs or Trust Products which are
widespread in Chinese shadow banking cause the same risks and can be the same
opaque to the complicated derivatives. Moreover, China’s shadow banking is linked
with the real economy to a greater extent. It means that if the crisis happens, the
problems of the institutions forming the shadow banking will have a great impact
on the real economy. Among the most endangered entities are: real estate develop-
ers, coal miners and steel makers. e dangers stem from some trust companies, in-
volved in lending to the branches and endangered by maturity mismatch.
During the last several years the Chinese shadow banking was very helpful for
the real economy, but in time of turbulence it will have the opposite eect. e tra-
ditional banks by participation in the shadow banking started lending to local gov-
ernments and supplying large, credit intensive infrastructure projects. Many of the
projects were of poor quality (e.g. returns do not compensate risks). If some of the
long-term investments fail, the banks will have big nancial problems in the future.
In a case of default the investors are prone to lose their capital. e other threat aris-
es from the fact that the WMPs are associated with liquidity risk. e products at-
tracted short term deposits and invested in longer term investments. In case of li-
quidity problems, there will be negative inuence on banks and other institutions,
which are not able to roll out their liabilities.
Originally among the WMPs’ investors were real estate companies and mu-
nicipalities. Unfortunately since 2013, these businesses were slowing down and
banks decided to change the form of investment and put their money into the
stock market. It means that the shadow banking in China has transformed from
a relatively safe into a more risky investment system. An essential issue is that they
did it in a very leveraged way, converting equity investments into structured prod-
ucts. ey used the underlying stocks for creation xed-return products and varia-
ble-return products (Archarya, Qian, & Yang, 2015). e rst category of products
were oered for ordinary depositors and the second for hedge funds and other
investors with riskier investment proles. is mechanism meant linking bank-
ing operations with capital market. It created high leverage and contributed to the
creation of a speculative bubble in the Chinese capital market. e whole situa-
tion generates a danger for Chinese banks of a loss given default (Altman, 2015).
If there will happen a crisis, the future of the whole system will depend on wheth-
er the banks and regulators will be able to prevent run on the shadow banking in-
stitutions in China.
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Regulatory responses to the Chinese shadow banking development
A very important danger associated with the Chinese shadow banking is its
impact on the world economy. eoretically the threat of the Chinese nancial
market for the world economy should be unimportant because the size of the mar-
ket is insignicant. Banking debt problems in emerging markets should be rath-
er domestic without global systemic implications. Despite this some analysts have
a fear that if something wrong happens in the China’s nancial sector, it can spill
over to foreign banks and investors, because China is becoming increasingly in-
tegrated with the global nancial system (Yao & Hu, 2015). If there are any prob-
lems in the Chinese capital market, the global economy will bear the consequenc-
es. Even if the threats will cause only a slowdown of the Chinese growth, it can
send a shockwaves and have strong impact on the whole world economy. It shows
how important is the Chinese shadow banking. If it is better regulated, it will avert
the next global crisis.
4. Proposals for Chinese shadow banking regulation
e last turbulences in the Chinese economy have shown that regulatory reform
in the country’s nancial system is needed. e necessary regulatory changes for
the shadow banking sector were among the key guidelines developed by the Chi-
nese government in recent years. e Chinese authorities very strongly stressed the
need to regulate the shadow banking system in the 12th Five-year-Plan for the pe-
riod 2011–2015 (e 12th Five-year Plan..., 2012). Additionally in January 2014, the
Chinese government promulgated a document with respect to regulation of shad-
ow banking in China, entitled Circular of the General Oce of the State Council on
Relevant Issues of Strengthening the Regulation of Shadow Banking (Circular of the
General Oce..., 2013). It is the latest regulatory framework in China, related to the
shadow banking issues (Huang, 2015).
In general the regulatory approach concentrates on three important aspects:
– determination of the shadow banking supervision powers and clear ar-
rangements of their responsibilities,
– guidelines on transparency – e.g. rules of shadow banking statistics and in-
formation policy,
– regulations for institutions and products – e.g. referring to banks’ WMP,
trust companies, small-loan companies, etc.
A key issue for ecient regulation is proper institutional regulatory structure.
e current nancial regulatory framework in China is sector-based approach,
with separate regulators for banking, securities and insurance (the China Bank-
ing Regulatory Commission, the China Securities Regulatory Commission, and the
China Insurance Regulatory Commission). ey conduct the supervision togeth-
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Piotr Łasak
er with the central bank (the People’s Bank of China). e new regulation (Circular
No. 107) states, that the responsibility for shadow banking regulation is divided be-
tween all the enumerated supervisors. It states clearly that whoever approves the es-
tablishment of the shadow banking entity shall be responsible for regulating it. e
general opinion is that it introduces transparency for the supervision task, howev-
er some critics highlight, that sometimes shadow banking products are cross-sec-
tor in nature, what will cause some competence problems in the future. Despite this
shortcoming, the regulation is treated as a signicant achievement. At the inter-
national arena sometimes are applied dierent models of supervision (e.g. “twin-
peaks” model or “integrated model”) but in the Chinese context the adopted one
seems to be adequate to the challenges. Some changes should be considered for the
future but with the present level of the nancial market development the adopted
solutions seem to be sucient.
Shadow banking by its nature leads to a reduction of transparency of nancial
institutions and capital ows. In conjunction with regulatory arbitrage it leads to
a decline in the eectiveness of macro-prudential regulation and increase of sys-
temic risk. e enhancement of transparency is one of the most important elements
of the Chinese government strategy to ensure a sound development of banks and
non-bank nancial service providers. It is essential for securing the investor protec-
tion and the proper functioning of the nancial market. e Chinese banks are ex-
pected to disclose information accurately and in timely manner about all aspects of
the issuance, rolling over and maintain of WMP in order to make them more trans-
parent (Sekine, 2013). Some eorts in this direction have been taken e.g. in the area
of WMP products transparency was improved by requiring banks to maintain sep-
arate accounts for each WMP with transparent documentation of assets funded by
each WMP account. e use of funding pools by bank WMP and trust plans for
investment in non-standardized debt instruments was prohibited (Zhu & Conrad,
2014). ere is a need for increase transparency in non-bank lending activities. It
means that should be implemented some rules enabling better oversight and prop-
er risk management to facilitate more rational assessment of credit risk.
ere were some specic requirements among the regulations for the shad-
ow banking institutions and products. An example is the requirement of the China
Banking Regulatory Commission (CBRC) that commercial banks must limit their
involvement of WMP proceeds in credit-related assets at any time to below the low-
er of 35% of WMP fund balance or 4% of banks’ total assets. Another example re-
lates to trusts. e CBRC requires trust product to discontinue the asset/fund pool
business model (Yao, 2015).
In conclusion, the regulations already implemented in China will have two-di-
mensional impact on the country: impact on nancial institutions and impact on
the economy. e regulatory impact on nancial institutions means tightening the
regulations on shadow banking activities and the nancing conditions to the pri-
vate sector. Implemented restrictions not only tighten up the shadow banking ac-
315
Regulatory responses to the Chinese shadow banking development
tivities, but require traditional banks to move away from shadow banking business
and return to the traditional deposit-taking and lending business.
Shadow banking in China diers from the system in developed countries and
the fact determines its regulation proposals. e rst priority is strictly connected
with the reason of the emergence and rapid growth of shadow banking. Many sec-
tors and entities of the Chinese economy faced diculty in obtaining bank loan or
other sources of funding. is is especially apparent in the case of small and medi-
um enterprises (SMEs). Shadow banking (e.g. credit guarantee companies, leasing
companies, pawn shops) has become an important source of nancing many such
entities and households. e present regulatory reforms in China require very high
sensitivity in this area. On the one hand formal banks should be encouraged to in-
crease funding SMEs and households, but on the other hand such changes require
a lot of time. Regulatory changes should not cut o these entities of funding but it
should be more traditional, regulated way of funding.
Conclusions
e Chinese economy has been growing rapidly during the last two decades and
has a great inuence on the nancial market’s development in the country. e
market is asymmetrical – it provides funding primarily for the big, state-owned en-
terprises, but many smaller businesses (especially private), have problems with ac-
cess to the highly restricted banking nancing. is is the main reason of the shad-
ow banking development in China.
China did not restrain the shadow banking aer the nancial crisis of 2007
–2009. It has become quite the contrary, the crisis led to a greater development of
the credit intermediation behind the traditional banking sector. e process was
strengthened by the stimulus package, prepared by the Chinese government in re-
sponse to the crisis and strict government controls over the ocial interest rates.
e collapses on the Chinese real estate market and the stock exchange helped
to realize by analysts and the government, how is the real danger connected with
shadow banking. e high risk connected with the growth of Chinese shadow
banking has mobilized the country’s government to some regulatory reforms. e
changes include some key areas: new model of nancial market supervision, great-
er transparency on the operations hidden “in the shadow” and implementation of
prudential regulations for the shadow banking institutions and products.
It is dicult to anticipate the impact of the introduced regulations for few rea-
sons:
– e Chinese nancial market is in the middle of its development and the di-
rections of the development are unpredictable.
316
Piotr Łasak
– e eectiveness of the implemented regulations in China will depend on
the appropriate investment nancing policy, which is necessary for the real
economy.
– e existence of two contradictive regulatory eects – the unstable situation
of the economy forces the government to strengthen the regulation, but too
strict regulations are encouraging the market participants for locating their
transactions outside the ocial, regulated market.
– Similarly as in the other developing countries in the past, further develop-
ment of the Chinese economy will be dependent on its opening, which in
turn will weaken the national regulations in the confrontation with foreign
capital.
e awareness of the risks generated by the shadow banking system is increas-
ing, so for sure it will cause greater attention on this sector than in the past. Only
such approach, combined with a exible response to occurring processes and new
threats are able to provide greater security of the Chinese nancial market.
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Note about the Author
P Ł, PD – Assistant Professor in the Institute of Economics, Finance and Manage-
ment, the Jagiellonian University. His research interests focus on topics related to internation-
al nancial markets development and regulation.
