Working Paper

What we learn from China's rising shadow banking: exploring the nexus of monetary tightening and banks' role in entrusted lending

Abstract: We argue that China's rising shadow banking was inextricably linked to potential balance-sheet risks in the banking system. We substantiate this argument with three didactic findings: (1) commercial banks in general were prone to engage in channeling risky entrusted loans; (2) shadow banking through entrusted lending masked small banks' exposure to balance-sheet risks; and (3) two well-intended regulations and institutional asymmetry between large and small banks combined to give small banks an incentive to exploit regulatory arbitrage by bringing off-balance-sheet risks into the balance sheet. We reveal these findings by constructing a comprehensive transaction-based loan dataset, providing robust empirical evidence, and developing a theoretical framework to explain the linkages between monetary policy, shadow banking, and traditional banking (the banking system) in China.

Keywords: Regulatory arbitrage; asset pricing; institutional asymmetry; entrusted loans; risk taking; shadow loans; bank loans; nonloan investment; nonbank trustees; small banks; large banks; balance sheets; optimal decisions;

JEL Classification: E02; E5; G11; G12; G28;

Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 2016-01-01

Number: 2016-1

Pages: 63 pages