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Shadow Banking in China (Chen, Ren and Zha 2018 AER)

Shadow Banking in China receives rising attention from both the press and the academia. In  The Nexus of Monetary Policy and Shadow Banking in China  (2018 AER, NBER WP23377,  NBER WP21890), Chen, Ren and Zha discuss the interplay between China's quantity-based monetary policy and commercial banks' reaction in terms of shadow banking activity. In this blog, I highlight their theory and  findings on shadow banking in China.

One feature in China's banking system is an institutional division of state and nonstate commercial banks. State banks are state owned and the remaining commercial banks, as a whole represent almost half the size of the entire banking system, are nonstate banks. State banks adhere to the government's own policy against actively bringing shadow banking products into their balance sheet. This is not true of nonstate banks, however. As found in the paper, nonstate banks take advantage of regulatory arbitrage by bringing shadow banking products into a special investment category on the asset side of their balance sheet, account-receivable investment (ARI), which is not subject to the regulations on shadow banking.

The paper proposes a tractable theory of banks' optimal portfolio problem to explain the incentive to expanding shadow banking business when they face contractionary monetary policy. When monetary policy tightens unexpectedly, the cost of attracting deposits increases and banks need to invest into assets with higher return (more risky assets) to offset the cost. If banks can exploit regulation arbitrage, they could promote shadow banking  by bringing off-balance-sheet products onto the balance sheet in a category shield from government regulation and by participating in more off-balance-sheet shadow banking activity.

They test the theory by providing two sets of empirical evidence: one on the entrusted loans facilitated by banks/other financial institutions to  represent off-balance-sheet shadow banking activity; one on ARI excluding central bank bills to represent on-balance-sheet shadow banking activity. The find a significant increase in both off-balance-sheet and on-balance-sheet shadow banking activity by non state banks, while no such evidence for state banks.

This implies a serious problem for the effectiveness of monetary policy. When the monetary policy tightens, the bank loans do decrease, but the amount of shadow banking activity increases. The total credit, the sum of bank loans and shadow banking assets, could rise instead of falling. This means the contractionary money policy is ineffective if there is no regulatory restriction on banks' participation in shadow banking activity.

Reference
Chen, Kaiji , Ren, Jue and Zha Tao, The Nexus of Monetary Policy and Shadow Banking in China, AMERICAN ECONOMIC REVIEW (FORTHCOMING)

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