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Decoding shadow banking from the Financial Stability Board

What is Shadow Banking ? Does it pose a threat to the stability of China's Financial System?

The term shadow banking is not new, however, it came into large use only recently and there is no particular definition for the term. The Financial Stability Board (FSB) widely described the term as the intermediation of credit that involves the activities and the organizations outside regular banking system. The People’s bank of China (PBOC) utilizes the definition of the term shadow banking that demands to take particulars on their own “national situation under the full account”. Whatever be the definition, the shadow banks undertakes the same tasks and presumes the same risks as the banks, for instance, the activities associated with credit, maturity and the transformation of liquidity (Lardy 2013).

Te definition of shadow banking is exposed to practical difficulties with regard to its precise definition as well as the usefulness for explaining the real world. Further, it is not easy to draw the borders among those activities and institutions that are guaranteed by and not guaranteed by the governments (Elliott, Douglas, Arthur Kroeber, and Yu Qiao 2013).

The system of shadow banking attracted much attention before global financial crisis that started during 2007. However, it became one of the root causes for the worst depression in the financial depression. There are two methods that explain the causes for the financial crisis. As per the theory of global saving glut, it is the high savings that influenced the flow of money from the emerging market economies and assisted in pushing the interest rate on the long run to be down to the bottom level. Further, the Financial Stability Board (FSB) indicated that during 2002 to 2007, the system of shadow banking increased to US$33 trillion and the size of the assets doubled from US$27 trillion to US$67 trillion. The shadow banking is considerable increasing over the past years not only in China but in the other parts of the world and the IMF has advised that the Shadow banking sector of China shall be monitored appropriately (Lu, Yunlin, Haifeng Guo, Erin H. Kao, and Hung-Gay Fung 2015).

There are various causes that attributed to the rapid growth of shadow banking after the financial crisis. They are –

  • Increasing of the interconnectedness and financial deregulation: the procedures of deregulation experienced the shadow financial institutions, for instance, NBFCs are becoming much more interconnected with the other sectors of financial system and much more complex with regard to the risk-taking approaches and activities. Thus, they are becoming more vulnerable with regard to other financial markets that increase the systematic risk (Elliott, Douglas J., and Yu Qiao 2015).
  • Financial exclusion: the small personal businesses and the SMEs find it costly and difficult for accessing the credit from the formal bank and the gap is filled by the NBFCs. The poor people are denied the load owing to low income, lack of sufficient collateral and the possibilities of default. However, the microfinance offers easy access to the funds to the self-employed and the poor people at high interest rate. As the poor have no other options, they avail the loan with higher rate of interest only (Riasi, Arash 2015).   
  • Formulation of the regulations and the supervisory rules that governs the banking institutions
  • Responsibilities of the supervisory board’s administration for the major banking institutions owned by the state and the other activities that are delegated by state council (Ueda, Kenji, and Yuko Gomi 2015)
  • Authorize the changes, termination, business scope and the establishment for the banking institutions.
  • Conduct the fit and proper tests for the senior management under the banking institutions (Hsu, Sara, and Jianjun Li 2015).
  • Publish and compile the reports and statistic of the overall industry of banking as per the required regulations.
  • Provide the proposals related to the resolution related to the issues of the deposit-taking institution with regard to the required regulations
  • Conduct the off-site surveillance and on-site examinations for banking institutions and taking into considerations the enforcement actions against the rule-breaking behaviours (Hsu, Sara 2017).

Some people from China believe that the shadow financing over China is the banking reform that has gone wrong. The shadow banking is a sign that the banks are circumventing the regulations with regard to increase or at least protect the margin of profit. However, as per the critics, this led to the possibilities of high amount for the bad debts on the bank books. As the Chinese government accounts the banking as as the strategic industry, this issue is quite bigger. In the true sense, the shadow banking is not actually banking as it includes all types of investment products that include private equity and mutual funds. The term shadow banking sometimes called as the “loan from bank in disguise” (Huang, Robin Hui 2015). As per the G20’s financial stability board 2015, China’s shadow banking was approximately 26% of the GDP during 2014 that was much lower as compared to the 59% average of other countries. Therefore, the most important and interesting development in China was the growth of the trusts. These trusts are the major form of equity investment and listed assets like money market and loans. Thus, they offer the banks to provide finance to the higher-risk areas that are generally restricted as per the general regulations. Owing to the shadow banking, some of the products related to wealth-management were significantly successful and offered exceptional returns to the investors (Dang, Tri Vi, Honglin Wang, and Aidan Yao 2014). Further, the corporate sector may have to sit on the level of high-debt and the leverage under the household and government sectors is lower as compared to various developed countries. As the frameworks involves various factors like high probability of exceptional price volatility, trade barriers, liquidity, exchange controls and the associated risks with the emerging markets, the frontier markets are magnified. Further, due to the shadow banking, the prices of the stocks will be fluctuates dramatically and rapidly which in turn will have impact on individual organizations, sectors, general market conditions and the specific industries (Zou, Xiao-Peng, Yu-Xiao Pang, and Hui-Lin Zhu 2013).

Causes of rapid growth in shadow banking

The tightening of the regulatory system of China is targeted for reducing the leverage in the financial segment, particularly the assets that are funded through the wealth management products. However, this may direct to unintended consequences for higher risk in activities of other shadow banking in shifting the composition of banking sector, as per the analysts. People’s bank of china raised the rates of short-term policy twice during the year and developed tougher the assessment based on the macro-prudential for the financial institutions. The regulatory commission of China banking is also taking steps for curbing the risks of the products related to the wealth management and the online lending, guarantee chains of the borrower and the trusts. Borrowers in the division of  property, financer of industries and vehicles that are burdened by the overcapacity face that are reduced by the access to the loan of the international bank and the market for the domestic bond (Wang, Hao, Honglin Wang, Lisheng Wang, and Hao Zhou 2016).

Strength – The main strength of the shadow banking is that the system of shadow banking does not require any regulation. As there are so many regulations in association with the bank, this is the biggest advantage that can offset various associated disadvantages. No regulation required for raising the money through selling of the securities that allows the shadow banking to manage as much as risks possible without defeating the obligations. Reports and compliance procedures that can cost million dollars and disruption of the operation are no more required.


Weaknesses – Shadow banking is not supported by central bank. Therefore, they do not have any back-up that can protect them against the issues if the depositors withdraw their cash all of a sudden. Though the commercial banks indirectly back them up, however, it is quite tough to them for diverting cash into the shadow arm, especially during the crisis period.

Opportunities – lending provided by the asset managers is the crucial aspect for the effective capital market as the provision of additional credit are crucial to the borrowers, particularly during the distress period of the commercial banking. Further, the private equity funds, hedge funds and other funds will provide loan to the higher risk associated business, for instance, the start-up organizations. However, decisions for lending is usually taken after due diligence with regard to greater flexibilities.

Threats – the benefits from financed fund have its own costs as the asset managers face the risks associated with the regulatory structures and the operation of the assets. Shadow banking are exposed to various risks that may not have an impact on the conventional large banks. The main threats are as follows:

  • Credit risk an due diligence – e. while lending loan to the borrower, the procedures for assessing the credit risk of the borrower accurately, it requires complete disclosures and gatherings of the financial information of the borrower and availability of all the information may not be always available
  • Liquidity risk – shares from the ETFs and the open-ended mutual funds are generally tradable and redeemable whereas the invested assets are less liquid. Thus, easy liquidity and redemption options are not easy (Tsai, Kellee 2015).

Functions of China Banking Regulatory Commission

In last decades, China witnessed the boom under the shadow finance, specifically with regard to the entrusted loans. The banks use the shadow credit purchase in big size for circumventing the policy restrictions and the regulations related to bank loan. Proliferation of the shadow credit products and the increasing dependency on the wholesale and short-term funding could lead to the substantial risks with regard to the solvency of the borrower and the default of the corporate loan. Further, the risk related to stability may include under the potential risk for the defaults on the largely held shadow products with regard to the short-term investments associated with high-risk borrowers (Claessens, Stijn, and Lev Ratnovski 2015).

Government of China has taken various reforms for mitigating the threats associated with shadow banking. These are –

  • Peer to peer banking – the non bank capital raised from various sources that involves trust firms, brokerage firms, insurance firms and the platform for the peer to peer lending. These sources are lend to the stock investors through various innovative channels like offline private fund that matches with the organizations and structured organizations for the mutual funds. Further, one of the most significant developments throughout the stock market bubble is the business related to the matching business of online fund. The peer to peer platform of lending enables the match funding organizations to attract the huge individual lenders which in turn enables the mobilizing of large capital into stock market during the short time period (Li, Jianjun, Sara Hsu, and Yanzhi Qin 2014).
  • Underground banking system – under the underground banking system the money is transferred through the informal banking instead of the the formal banking and is recognized through the method that legitimately remitted from oversees workers that are transferred. However, the underground banking are regarded as the channel for money laundering and it is crucial for achieving the balance among regulation of the underground banking to decrease the flow of the illicit funds and giving permissions for the continuous usage of the alternative, legitimate remittance system (Li, Tong 2014).

Conclusions

It has been concluded from the above discussion that the financial system of China has shifted from the isolated, heavily regulated and bank-dominated system into the increasingly diversified, large and interconnected system. The transformation is developed the efficiencies of financial system and are expected to get benefits for the economic development over the short-term period. This is particularly exists while the financial systems are under excessive pressures from competition to expand them into the riskier market for the assets and the developed regulatory framework is not been kept in pace with the changes. However, the crucial question regarding this is is whether the coordinated arrangements that appeared to be efficient during crisis are equally suited with the normal condition sof operations

References

Claessens, Stijn, and Lev Ratnovski. "What is shadow banking?." (2015).

Dang, Tri Vi, Honglin Wang, and Aidan Yao. "Chinese shadow banking: Bank-centric misperceptions." (2014).

Elliott, Douglas J., and Yu Qiao. "Reforming Shadow Banking in China." Economic Studies at Brooking. Available at: https://www. brookings. edu/~/media/research/files/papers/2015/05/12-reforming-shadow-banking-china/elliott--shadow-banking. pdf (2015).

Elliott, Douglas, Arthur Kroeber, and Yu Qiao. "Shadow banking in China: A primer." Research paper, The Brookings Institution (2015).

Hsu, Sara, and Jianjun Li. "The rise and fall of shadow banking in china." Political Economy Research Institute, Working Paper Series Number 375 (2015).

Hsu, Sara. "Shadow Banking in China Shen Wei Northampton, MA: Edward Elgar, 2016 xiv+ 455 pp. $175.00 ISBN 978-1-78471-676-9." The China Quarterly 229 (2017): 232-233.

Huang, Robin Hui. "The regulation of shadow banking in China: International and comparative perspectives." Banking & Finance Law Review 30, no. 3 (2015): 481.

Lardy, N. "Shadow Banking in China." In Presentation at the Chicago Fed’s Sixteenth Annual International Banking Conference. 2013.

Li, Jianjun, Sara Hsu, and Yanzhi Qin. "Shadow banking in China: Institutional risks." China Economic Review 31 (2014): 119-129.

Li, Tong. "Shadow banking in China: expanding scale, evolving structure." Journal of Financial Economic Policy 6, no. 3 (2014): 198-211.

Lu, Yunlin, Haifeng Guo, Erin H. Kao, and Hung-Gay Fung. "Shadow banking and firm financing in China." International Review of Economics & Finance 36 (2015): 40-53.

Riasi, Arash. "Competitive advantages of shadow banking industry: An analysis using Porter diamond model." Business Management and Strategy 6, no. 2 (2015): 15-27.

Tsai, Kellee S. "The political economy of state capitalism and shadow banking in China." (2015).

Ueda, Kenji, and Yuko Gomi. "Shadow Banking in China and Expanding debts of Local Governments." Newsletter 23 (2013).

Wang, Hao, Honglin Wang, Lisheng Wang, and Hao Zhou. "Shadow banking: China's dual-track interest rate liberalization." (2016).

Zou, Xiao-Peng, Yu-Xiao Pang, and Hui-Lin Zhu. "The study between shadow banking and financial fragility in China: an empirical analysis based on the co-integration test and error correction model." Quality & Qua
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