Emergence of Shadow Banking in ChinaJOHN POWERS 12/9

Abstract of Report

Examines the emergence of China’s shadow banking institutions

Fundamental and structural reasons behind the growth of shadow lending in credit markets

Accuracy of risk modeling methods Determination that risks may be overstated

due to relative size of the economy and unique structure of financial system

Introduction

Traditional Banking: Commercials banks, mortgages, business loans, student loans, lines of credit etc.

Fractional Reserve Banking: Emergence of Central Banks in 1600’s.

Reserve requirements developed. Lender of last resort role established.

Heavily regulated but successfully regulated.

Shadow Banking

“Shadow Bank” term coined by economist Paul McCulley in 2007.

Refers to lending by non-bank financial intermediaries.

Not subject to traditional banking regulations. Credit expansion driven by complex financial

instruments, business to business lending, securitization vehicles etc.

Inherent Risks Revealed

Innovation allows for expansion of credit not hindered by Central Banks, traditional bank regulation

Extraordinary complexity in financial instruments

Important role in 2008 Global Financial Crisis Inadequate Risk Modeling Financial Contagion and lack of lender of last

resort

Emergence in Chinese Economy

1978 reforms by Deng Xiapong started process the economic reforms.

Second stage of reform in late 1980’s Mono Bank -> Multi-tiered Banks 1995 Charter for People’s Bank of China Monetary Stability, Banking Supervision,

Oversight of Payments System 1999 Commercial Lending outside of government

interference (formally)

Motivations for Lending

Specialization, innovation, regulatory arbitrage Not burdened by central chain of lending Tight regulatory measures on commercial

banking, lending, and scope of access in China. Large populace unbanked Social, economic and technological

advancement outpacing Chinese Financial System

Lending vs. Lending Target (Seminar, 2013)

Trust Asset Growth (Seminar, 2013)

Instruments

Wealth Management Products, Trusts, Off Balance Financial Transactions

Risk Modeling

Extremely difficult because of complexity of instruments and system of delivery

Trial and error method Constantly evolving system Sectors cannot be isolated from systemic risks Transparency an important component

Risks Overstated Near Term

Chinese economic makeup fundamentally different than Western Economies

High Savings Rates Relative Complexity of Instruments Unbanked Populace Tight Regulation Economic Inequlity

Conclusions

Expansion of credit needed for much of the populace

Shadow Banking may fill an important role that tight regulation creates

Risks may be overstated for the near future Reforms in Traditional Banking System still

needed.