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The report has been prepared to demonstrate the understanding of shadow banking. It also incorporates the discussion about threat to the financial system of China. Report also includes the analysis using the tool of PESTLE that depicts the China’s external environment concerning the financial system. With the explanation of the shadow banking in context of China has been symbolized as failing of the financial system leading up to the global financial crisis. Inclusion of PSETLE analysis in the assignment helps in gaining in depth understating about the environment relating to political, technical, environmental, social and legal that would impact the financial system. Shadow banks in China are the banks that presuppose parallel risks and perform parallel functions as that of bank. Shadow banking in China in the present study has been viewed in context of system that will be dominated by banks through a variety of formal and informal guidance and regulations (Adrian and Adam 2016). In the later part of report, recommendations have been provided for reforming the shadow banks and implementation of changes relating to the wider financial sector.

The system of shadow banking represents a network of financial institutions that comprise of several non-depository banks such as hedge funds, structured investment vehicles, investments funds, money market funds and some non-banking financial institutions. Sine such shadow banks have escaped most of laws and regulatory limits imposed on traditional banking sectors; they do not receive traditional banking deposits. For unregulated activities, members of shadow banks are able to operate without being entitled to regulatory oversights for such activities. Credit facilities have been significantly increased throughout the global financial system with many institutions in shadow banking system playing significant role. Institutions of shadow banking serves as intermediaries between borrowers and investors that provides capital, credits to corporations, institutional investors (Errico et al. 2014). Such institutions generate profits from their fees and interest rates in arbitraging.

Shadow banks do not have access to funding provided by central banks and does not have safety nets like depository insurance. Shadow banks do not take deposits like traditional banks and they are mainly reliable on short term findings that are assisted by repo market or asset backed commercial paper. Borrowers against a cash loan offer collateral as security and then sell it to lender by agreeing entering into an agreement to repurchase it in future at an agreed price. However, there are certain risks that are associated with shadow banking as their activities can mount up the risk in financial system (Claessens et al. 2015). This is so because the rewards they get receive from investment increases by leveraging up more than their counterparts. Shadow banks contributes in indirectly building up systematic risks as they are interconnected to traditional banking system and this is indicative if the fact that problem that exists in the system can be rampant to traditional banking system.

Shadow Banking Explanation

Shadow banking was the core of what happened to bring about global financial crisis that happened in late 2000s. Since shadow banks does not have deposit insurance and they make use of short-term deposit funding and it shows that such problems can lead to run on these unregulated institutions.

The collateralised funds of shadow banking are also regarded as risk as there can be high level of financial leverage. Nonetheless, the shadow banking system is very essential for economy as provides funding to traditional banking system as if there is no funding, there would be lower lending of money that would contribute to slow growth of economy.

Shadow banks helps in providing access to credit to people and entities that might not otherwise have access.

Political Factor- Political force in China is the most unsettled force and the main focus of government in current year is focusing on e commerce business. The republic of China is a socialist state under the democratic dictatorship that is based on alliance of peasants and workers. The laws and constitution of China involve due process and fundamental human rights and there was modification in laws of constitution. Modification has led to the promulgations in bankruptcy law and anti monopoly law and modification for both laws and company.

Economic Factors- China has a huge potential for economic growth that leads to accessing in large markets and considerable savings in the cost of labour. There is a dual economic structure that has evolved from centrally planned economy and China has been a primary recipient of the world destination of foreign direct investment. Economic growth of China has been stifled by central bank that took caution to risk by delaying purchase to diminish demand. Economic policies of China are liberal that has strengthened economy of China. Holding of currency in China has been manipulated at artificially low levels.

Social Factors- China have an estimated growth rate of 0.494% and population of over 1.3 billion and population growth one of the huge concern. There has been the implementation of birth limitation policy. Another aspect to be considered is the employment trend in relation to level of unemployment. The unemployment rate in year 2014 stood at 4.3% which is demonstrative of the fact that the various business projects will help in creating positive opportunities for job and would help the society in turn. It is essential for China to maintain higher growth rate to improve then financial system by establishing the social security system. The dramatic growth of China since 1978 has increased social mobility and this has resulted in expansion of personal freedom scope. Chinese cultural incorporates the values that have hierarchal social life structure, self restraint, morality cultivation, importance of family and they give emphasis on hard values and achievement (Engle et al. 2015). They intend to fulfil social obligations and social events are not considered as the place for business discussion. However, social etiquettes are considered crucial to follow for taking business decisions.

China’s Financial System PESTLE Analysis

Technological Factors- The technological factors has impacted the banking and financial system of china directly and indirectly. Contribution of information technology has enabled the financial system with providing unprecedented opportunities for advanced and sophisticated level of interactions. The state owned banks of China has revealed several difficulties faced in securing stable technological infrastructure. Technological adoption n banking system has led to the evolution of front counter saving system for financial intermediary role and has led to control and coordination in banking system. Task of technology application has become complicated and difficult due to development of new system and tasks in the transitional market economy.

Legal Factors- The financial and banking system of China is heavily influenced by government, however it lacked regulatory and proper legal scheme. The two stock exchanges of China that is Shenzen stock exchange and Shanghai stock exchange has the legal framework that lags the growth of the stock market. China has little knowledge about drafting legislation for some e business such as tax and intellectual property rights protection. Country does not have any regulations for supporting the recognition of digital signatures of consumers and privacy of consumer rights (Pleantin 2014).

Environmental Factors- The environmental impact on China has been negative due to rapid industrial development. Leader of China has been increasingly playing role and attention in the environmental problems. Environmental issues have been posing serious threat to development of economy of China. The ministry level agency of China was upgraded by the state environmental protection agency.

Country has been actively participating in the talks of climatic change and other multilateral environmental regulations. They are currently dealing with the serious environmental issues that are impacting the economy of China. It is a huge country and scarcity of water is regarded as the biggest issue and this is leading to disadvantage of project. Climatic change is affecting the way organizations operate and the type of products they offer (Allen et al. 2016). Climatic change is considered as one of the major systematic risk for Sound technology.

The definition of shadow banking does not come with agreed definition and as per the financial stability board, shadow baking is the credit intermediation comprising of activities and entities outside and inside the regular banking system. There are significant economic costs and benefits associated with shadow banking in China. Shadow banking helps in providing loans at lower costs and operates cheaply than other formal banks (Plantin 2014). The price competitiveness and flexibility comes at the safety margins expense.

This is so because banks are required to have considerably more liquidity and capital compared to traditional and formal banks. It is regarded as expensive and nonetheless, banks are safer using this technique. Economic growth can be spurred by shadow banks at the cost of financial stability and this compel the policy makers into critical balancing acts for minimizing the risks and maximizing the benefits.

There is an added factor to balancing act in China and it is recognized by authorities in country that there is a need for liberalizing the financial sector for reducing the banking decisions with a range of important reforms.


Composition and size of China’s shadow banking:

(Source: Ratnovski et al. 2014)

Shadow banking in China is viewed in the context of system that is dominated by large state controlled banks. One of the key questions facing China is whether financial system would be subjected to severe crisis in light of shadow banking. It is certainly possible that such system of banking would develop crisis as China is currently going through some economically difficult adjustments that would trigger losses in loans (Bengtsson 2014).

There is too much reliance on implicit guarantees and little transparency in shadow banking along with large hidden problems. The financial system of china is much more complicated as compared to previous time when it was rescued by government. Shadow banking sector in China is not regularized by international standards and it has low level of instruments such as derivatives and securitized assets. All these facts are the most important risks that regulators oversee it. Maintenance of financial stability might be threatened due to nip in bud practices. One of the fastest growing margins in shadow banking is in China at the rate of 272% of GDP. The sector of shadow banking in present form in china presents relatively lower risks of triggering a financial crisis. Elementary reason attributable to this fact is that China has abundant liquidity resulting from high level of deposits by households and businesses. Reliability of business on flimsy wholesale funding has reduced. Funds of banks in Chin would not be imperilled by some unfavourable events such as slow down of dramatic heavy industry, crash of property market and defaults made by trusted companies that will lead to emergence of nonperforming assets. Crisis is not regarded as the biggest financial system risks rather the share of lending into projects that are not producible are likely to decelerate the economic growth (Adrian 2014).

In order to make shadow banking to have positive impact on economy of China, it is recommended that shadow activities should be made more transparent along with embodying it is regulatory documents. Institutions in the shadow banking sector are required to place limits or restrictions on meeting the requirement of capital for transactions off balance sheet and exposures to individual counterparties. Nonetheless, the balancing acts between the protecting the investors and financial system stability and motivating shadow banks for supplying credit to needed sectors becomes difficult.


From the above discussion and analysis it can be concluded that financial authorities in China is that the complex financial needs of economy is not serviced by conventional banking sector. Moreover, the shadow banking sector is not regulated by international standards. There is lower funding risk due to availability of aggregate resources deployed under the policy of right regime. Considering all the discussed facts, it is concluded that near term risk to wider economy and financial sector in China is low. However, in the event of occurring such crisis, the impact would be contained and there would not be serious contagion to the financial system.


Adrian, Tobias, and Adam B. Ashcraft. "Shadow banking: a review of the literature." In Banking Crises, pp. 282-315. Palgrave Macmillan UK, 2016.

Adrian, Tobias. "Financial stability policies for shadow banking." (2014).

Allen, Franklin, Yiming Qian, Guoqian Tu, and Frank Yu. "Entrusted Loans: A Close Look at China's Shadow Banking System." (2016).

Bengtsson, Elias. "Shadow banking and financial stability: European money market funds in the global financial crisis." Journal of International Money and Finance 32 (2013): 579-594.

Chen, Zhuo, Zhiguo He, and Chun Liu. "The financing of local government in China: Stimulus loan wanes and shadow banking waxes." (2017).

Chernenko, Sergey, and Adi Sunderam. "Frictions in shadow banking: Evidence from the lending behavior of money market mutual funds." Review of Financial Studies 27, no. 6 (2014): 1717-1750.

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

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

Engle, Robert F., Fariborz Moshirian, and Christopher Wong. "Global systemic risk: What's driving the shadow banking system?." (2015).

Errico, Luca, Artak Harutyunyan, Elena Loukoianova, Richard Walton, Yevgeniya Korniyenko, Goran Amidžic, Hanan AbuShanab, and Hyun Song Shin. "Mapping the shadow banking system through a global flow of funds analysis." (2014).

Laeven, Luc. "Financial innovation and shadow banking." The social value of the financial sector: too big to fail or just too big (2014).

Moreira, Alan, and Alexi Savov. The macroeconomics of shadow banking. No. w20335. National Bureau of Economic Research, 2014.

Pleantin, Guillazum. "Shadow banking and bank capital regulation." Review of Financial Studies (2014): hhu055.

Ratnovski, Lev, and Stijn Claessens. What is Shadow Banking?. No. 14/25. IMF Working Paper, 2014.

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

Sunderam, Adi. "Money creation and the shadow banking system." Review of Financial Studies (2014): hhu083.

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