The understanding of shadow banking in context of financial system of China has been demonstrated in the report. It also embodies explanation about whether such system of banking poses threat to the financial system of China. Report is prepared to investigate shadow banking system role in the financial system of China from the perspective of its distinction with conventional banking system. The analysis of external macro environment of China is done by using the PESTLE analysis. This takes into consideration all the social, environmental, political, technological and economic factors into considerations. The explanation of shadow banking has been signified as the failure of financial system leading to global financial crisis (Allen et al. 2016).
Explanation of Shadow banking:
Shadow banks are considered as the financial firms possessing similar risks and performing similar functions as that of traditional banks. However, they do not adhere to the regulations. According to Financial stability board, shadow banking is defined as the credit intermediations comprising of entities and activities outside the regular banking system. Some of the activities of shadow banking can be listed down as transformation of liquidity, credit intermediation and maturity transformation. For different economies, shadow banking takes in different forms. Shadow banking institutions performs the function of securitization through transformation of risk in less developed economies. Financial institutions of shadow banking perform supplementary role to traditional banking system in less developed economies (Dang et al. 2014). Environment in which such financial institution function are less transparent and less regulated.
Securitization market development in China is lagging behind some of the highly developed derivatives market due to failure of certain legal system. There are own characteristics of shadow banking in China and they are becoming substantial partners and competitor of commercial banks. Such banking system is different in China and it deals with not only non-banking activities but also acting as financial intermediation performing the activities such as wealth management products, underground banking and some other non-balance sheet loans such as claims held by commercial banks. However, the operating model of shadow banking is similar to commercial banks. Funds for Such financial institution are collected from deposits of banks at lower rate of interest and they lend at higher interest rates and thereby replacing the role of commercial banks. An asset backed securities are being developed by commercial banks by cooperating with non-bank financial institutions such as asset management and trust companies (Elliott et al. 2015). There has been a rapid growth of shadow banking system in China owing to the process of financial intermediation.
Shadow banking system in China is acting as intermediary for providing funds to entities and small medium enterprises who finds it difficult to obtained finance through the conventional channels arising from liquidity imbalance. Shadow banking system in China comprised of three main parts. The development of shadow banking in China resulted from liquidity. Economic growth of any country can be stimulated by shadow banks as it makes the financial service cheaper. In China, such banking system is viewed as a system dominated by large state controlled banks (Yao et al. 2015). There are various reasons that is pushing business towards shadow banks and away from conventional banks. Some of the fact includes:
- There is a constraint on limits of deposits of 75% of bank loan.
- The lending volume of banks comes with cap that is enforced by People’s Bank of China.
- Costly reserve requirements of People’s Bank of China are avoided by shadow banking.
- Regulators discourage lending to certain industries.
- Most of the non-bank channels have lower liquidity and capital requirements.
- There is no limitation on deposits ns loans rates of shadow banks and they are not subjected to bank limits.
PESTLE analysis of China’s financial system:
Political factor-China is considered as a politically stable company having high foreign reserves and current account surplus. For foreign direct investment, China is one of the top largest destination. In terms of labour, country has the advantageous position and with the population of 1.37 billion in year 2015. With respect to political risk, China is regarded as particularly hazardous and there needs to be consideration of possibility of industries nationalization. China has one unique form of political risk and there is a constant battle between provincial, local and central government. This makes it difficult for organization to know the exact rules under which it can operate. Modification in the constitution law has resulted in proclamations of anti-monopoly and bankruptcy laws along with modification of both company and laws operating it (Hachem et al. 2015).
Economic factors-The economy of China continues to grow and prosper and there has been an increasing outbound of direct investment in country. China is entering into new phase of economic development and financial system of China is expected to play a major role in economic transition. The centrally planned economy in China has led to the evolution of dual economic structure. Central bank has subdued China by delaying purchase that has reduced demand. Economy of China has been strengthened by liberal economic policies.
Social factors-There is likely to have social and economic distress resulting from lower commitment and involvement of government. China has implemented policy of limiting birth. Rate of unemployment stood at 4.3% in year 2014 and this demonstrate that positive employment opportunities would be created by various opportunities. Social security system will help in improving financial system by maintaining higher growth rate. Culture of China depicts structure of hierarchal social life, cultivation of morality, self-restraint while emphasizing on achievement and hard values (Li et al. 2014). Business decisions are takenby considering social etiquettes.
Technological factors-The financial and banking system are indirectly and directly impacted by various technological factors. Chinese firms encounter much difficultyas they lack the necessary capabilities. Financial institutions in upgrading to sophisticate technology face difficulties. Sophisticated and advanced level of interactions in the banking system is enabled by providing unparalleled opportunities. China has been facing difficulties in securing stable technological infrastructure in state owned banks. However, there has been increased coordination and control in the banking system due to several technological adoption such as evolution of front counter saving system. Application of technology in the transitional market economy has become difficult and complicated (Dang et al. 2014).
Legal factors-Government in China heavily influences the banking and financial system. Nonetheless, there is no proper and regulatory schemes. Growth of stock market such as Shanghai stock exchange and Shenzhen stock exchange has such legal framework that lags growth. China lags in knowledge required for drafting some of the legislation such as intellectual property rights and taxation protection. There is no regulations for supporting the identification of digital signatures for protecting the privacy and rights of consumers. Government on intensity of loan department of organization to provide specific loans amount imposes legal limits (Volz 2015).
Environmental factors-Due to rapid and intensive development of industries, the impact of environment in China is negative. Government in Chin has been increasingly paying attention to deal with the environmental challenges. Development of economy has been posed with serious threat due to environmental issues. There is an active participation in climatic change by country and various measures are taken by them to deal with the issues for aligning with the development of economy. One of the biggest environmental issues is water scarcity that is affecting the various business project. Climatic change is resulting in systematic risk for ground of sound technology development.
China’s financial system stability and shadow banking:
The development of shadow banking system has affected the effectiveness of monetary policy of central banks. The effectiveness of credit sale limitations was raise by central banks with the existence of extra providers of loans. Shadow banking lending in Chin has resulted from regulatory arbitrage and they are featured as “bank loan in disguise” (Bottelier et al. 2015). Nature of shadow banking comprised of entrusted loans, interbank entrusted loan payment, trust loan and leases, financial leasing, guarantees, bond markets, wealth management products and bankers acceptance.
Estimates of size of shadow banking sector of China:
(Source: Li 2014)
One of the crucial question faced by China in light of shadow banking system is whether such system would lead to severe financial crisis. In the current period, China is undergoing some economically difficult adjustments that would generate loss. Shadow banking system comes with some large hidden issues as it relies too much on implicit guarantees and has little transparency. Financial system of China in current situation is very much complicated and the current shadow banking system is not regularized by international standards. Regulators oversee some of the risk arising from such banking system. The grasp in bud practices might threatened the stability of financial system. Shadow banking in China is growing at the rate of 272% of GDP (Hsu et al. 2015). It can be viewed from various findings that there is relatively risks arising from shadow banking that would generate instability in the China’s financial system.
Formal banking sector in China has a stake in shadow banking sector and shadow credit provided straightforward lending that helps in satisfying normal credit demand that cannot be met by banks. Some of the major risk in shadow sector is trust-lending companies that suffers from maturity mismatch. It has been investigated that credit expansion in year 2013 and 2014 has arisen from other than bank lending (Tsai 2015). It is difficult to bring a balancing act between the maintaining the financial stability of investors and economy and encouraging shadow banks to supply credits in the sector that traditional banks does not serves.
Composition and size of China’s shadow banking:
Some of the fundamental reasons attributable fact that is the plentiful liquidity arising from high level of saving deposits by businesses and households. Liquidity available in China would not be jeopardized by events such as crash in the property market, slowdown of theatrical heavy industries and defaults made by several trusted companies. Nonetheless, arising of financial crisis would not be considered as biggest risks that would decelerate the economic growth. Balancing acts in China comes with an added factor recognized by authorities. The financial sector of China needs to be liberalized for introducing the banking decisions with the introduction of several reforms (Zhang et al. 2013).
It is recommended that regulatory authorities should remain objective with respect to the shadow banking system. Regulators for strengthening the shadow banking system and providing a sound regulatory environment should take efforts. Government should try to take the advantage of the influence of shadow banking system on money supply and economic growth. The main obstacle of economic development in China is financial difficulty faced by small enterprise and therefore, it is required by regulatory authorities to take full benefits of trust and entrusted loans and thereby guiding the development of shadow banking system. Regulatory authorities should limit the maximum interest rate value on shadow banking system. Since shadow banking has significant role to play in financial system of China, it should be regulated in the scope of supervision system of commercial banks as soon as possible.
The growing financial needs of economy of China are not fully serviced by conventional banking sector. International standards does not regulate the shadow banking and under the policy of right regime, there is risk of low funding due to deployment of aggregate resources. After the discussion of relevant factors, it can be concluded that the near term risk to the China’s financial sector and its overall economy is comparatively low. In the event of financial crisis, there would not be serious contagion to the economy of China and their financial system.
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