A shadow banking system is a collection of financial actors and entities that engage in bank-like transactions with light regulation or no regulation at all. Shadow banking provides access to finances—chiefly loans—that are unavailable to private businesses, especially small firms, through mainstream financial institutions. As an alternative to formal banking, shadow banking can dramatically expand—or contract—the effective supply of money in the economy. Shadow banking provides significant benefits to society by enabling lenders to service borrowers beyond the profitable reach of the formal sector and usually reducing transaction costs below levels in the formal sector.
Shadow banking is a gray-zone outside the scope of state regulation, which may bring systemic risks to the economic system and lead to crime arising from forcible debt collections. Chinese law for regulating shadow banking is currently vague and incomplete, frequently situating shadow banking activities outside the realm of regulation. Instead, the state relies upon criminal law administered through the courts to deter illicit shadow banking activities. Financial repression policies in China artificially fix interest rates, maintain a monopoly in the banking sector, control the payment system and impose barriers for private entry into the banking sector. The growth of a shadow market is a direct consequence of repressed deposit and loan rate policies in an organized market like China.
Like the organized banking system, shadow banking has its own assets and institutions. The primary function of shadow banking is to meet demands for money outside government control. Depositors get much higher deposit rates from shadow bankers than they would from the organized banking system. In addition, borrowers that have been denied by organized financial institutions can borrow from shadow banks but are subject to extremely high interest rates.
In China, the distribution of bank credit does not efficiently allocate to the most productive uses, even though the private sector is the most dynamic part of the Chinese economy. According to statistics, in 2012 non-majority state owned enterprises contributed over seventy percent of the country's GDP and accounted for eighty percent of the labor force. However, influenced by state policy, banks are reluctant to grant loans to small private companies. State-controlled banks extend only a small percentage of loans to private businesses. Lacking access to bank resources and the capital market, private companies—especially small ones—continue to rely heavily on retained earnings or funds raised from family and friends or shadow banking.
Unlike organized banks, shadow banks do not have lavish financial buildings, numerous branches or colorful advertising. In fact, they may have no established place of business at all and instead conduct their affairs in cafés, bars and back alleys. Some shadow banking entities may be mere individuals, while others may be small associations with informal and loose structures. Pawnshops, guarantee companies, micro-loan companies and money houses are the major institutional players in Chinese shadow banking, which occupies within a gray-zone but feeds into the traditional system. However simple their organizational structures are, these outfits typically engage in normal bank-like activities such as taking deposits and making loans. In doing so, they rival organized banks by offering higher return rates for savings and being more accessible to borrowers. The estimated size of the shadow banking system in China is extraordinarily large, in 2012 it totaled around 30 trillion Yuan—$4.8 trillion.
Shadow banking provides highly efficient financial channels for small enterprises. These small enterprises usually need a loan approval within ten days which cannot be satisfied by less efficient state-controlled banks, joint-stock banks or city/rural banks that require at least two weeks for approval. Chinese commercial banks have a three-level approval process, which requires risk management to investigate and report to an upper-level credit committee for further investigation. For most loans, the credit committee makes the final decision, but for those more than 10,000,000 Yuan—$1,640,530—the committee may need approval from a board of directors. Thus, it typically takes two to three months for a business to secure a loan from a commercial bank, a time frame that does not meet the fast processing demands of a small enterprise.
Although the financial 'great wall' in the organized market appears impregnable, it does not prevent collusion between actors in the organized market and those in shadow banking system. To increase their profits and expand their funds, shadow institutions may secretly cooperate with commercial banks to arrange more profitable transactions. In some cases—like collusion between a loan guarantee company and a commercial bank—the commercial banks may be happy to work with such a partner to maximize profits. Thus, some of the funds lent in shadow banking come directly from formal banking entities. According to estimates [PDF], in 2011 thirty percent of shadow banking funds in Wenzhou came from traditional bank credit. When there are large-scale defaults by shadow bank clientele, as was the case in the Wenzhou Crisis, banking institutions may not be able to repay debts owed to commercial banks and the debt instability will thereby spillover into the formal financial system.
For shadow banking institutions, there is no external supervision and minimal internal risk management. Several problems arise from this situation. For one, none of the regulators overlooking shadow banking entities are professional financial regulators. The primary regulator for most quasi-financial institutions is the Department of Commerce, which is also not a professional financial regulator. Other non-professional financial regulators may be regulating quasi-financial institutions participating in the shadow banking system. Having non-professional financial regulators carries the risk of opening loopholes in the shadow banking system. Since the commercial banking regulators are not currently regulating the shadow banking institutions, it is hard to monitor the risky business that goes on between them, such as between pawnshops and banks.
Moreover, shadow banks are not required to make an official report of their financial affairs to any authority. Since these institutions lack external supervision and proper internal risk control, they may very well collapse over time. The lack of a financial disclosure requirement allows quasi-financial institutions to absorb funds from channels and in manners that are illegal—such as taking deposits from the public, borrowing excessively from banks or even laundering money—which would likely be recognized and addressed if regulated through the traditional banking system. Some transactions in shadow banking are merely speculations, where fund-raisers use high interest rates to attract deposits in order to accumulate capital and pay off previous obligations with new deposits. Thus, a default of the final repayment will inevitably result in the collapse of the entire chain. Such a collapse would likely cause economic hardship to market participants and lead to social instability.
The best option for the state—in order to maintain the benefits provided by shadow banking in the economy while mitigating the associated risks—is to include the shadow banking system within the scope of financial regulation. However, the Chinese government has yet to do so, for two reasons. First, the government does not recognize the benefits of shadow banking, but instead labels them under existing laws as quasi-legal or illegal, regardless how unreasonable or unfair this characterization may be. Second, the government attempts to coerce shadow banking entities, even though the government has no sufficient authority to do so. The government chooses to impose excessive criminal penalties in order to deter dangerous shadow banking activities.
The problem of shadow banking in China calls for a pragmatic solution. To prescribe the right solution, we first need to understand what caused the problem in the first place. The government's use of financial repression has created privileged and unprivileged sectors in the economy with respect to the availability of credit, the former having access to cheap rates and the latter being crowded out. This process operates through laws and regulations, such as those fixing interest rates, erecting entry barriers into the banking industry, and intervening in credit allocation.
The state should incorporate the shadow banking system into the scope of financial regulation. A fluctuating market-based interest rate will encourage banks to lend to small business if they can charge premiums commensurate with the risks they assume. Moreover, qualified private enterprises should be allowed to issue bonds. This would go a long way towards relieving capital shortages by lowering borrowing costs for private businesses. Bank regulators can also increase competition by lowering the barrier of entry private institutions face in the banking industry. This would also ensure that banking entities are not forced operate in the back alley of law. Shadow banking activity should be subject to the supervision of traditional banking regulators so potential risks can be identified and addressed before they become systemic issues. With active banking regulators, the state will not have to rely solely on draconian criminal punishments in order to deter illicit shadow banking activities. Finally, in the long run, the government should mandate deposit insurance for all deposit-taking institutions. Such a policy will foster fair competition in the banking market between the big banks and the small ones.
Bashar Malkawi is Associate Professor of Business Law and Associate Dean of Graduate Programs at the University of Sharjah College of Law in the United Arab Emirates. Dr. Malkawi obtained an LLM in International Trade Law from the University of Arizona and an SJD from American University, Washington College of Law. He previously served as the Legal Drafter and Reviewer for the Government of Iraq and the United States Agency for International Development (USAID) and Consultant for the Center for Institutional Reform and the Informal Sector and Department for International Development..
Suggested Citation:Bashar Malkawi, Back-Alley Banking in China: The Next Financial Crisis , JURIST - Forum, Nov. 8, 2013, /forum/2013/11/bashar-malkawi-banking-china.php
This article was prepared for publication by Kenneth Hall, assistant editor for JURIST's Academic Commentary service. Please direct any questions or comments to him at firstname.lastname@example.org