Understanding shadow banking
In China and elsewhere, shadow banking usually is not the nefarious, illegal activity that the name implies. Although loan sharks and shady deals do fall into the shadows, more often the designation merely refers to alternatives to bank financing. Shadow solutions tend to occur when financiers have ample access to money but traditional lending sources don’t serve pressing needs. Shadow banking encompasses everything from highly securitized and leveraged credit pools to pawnshops.
How widespread it is
Shadow banking is huge globally, accounting for about one-fourth of total money transfers between savers and borrowers worldwide, estimates the International Monetary Fund. Moody’s Investor Service estimates that China’s shadow banking transactions equaled 65 percent of the nation’s GDP in 2014.
Why it’s different in China
China’s version far more resembles straightforward lending, with most shadow banking products developed as a way for banks to bypass government restrictions. Although interest payments may rise to twice the officially condoned rate in these off-balance-sheet vehicles, entrepreneurs can usually tap into loans carrying an annual cost of capital of under 14 percent. Because many activities in shadow banking are not transparent, and because regulatory oversight is nonexistent or significantly less stringent than applied to banks, the sector naturally arouses suspicions. Global bodies, including the IMF and Financial Stability Board, as well as local regulators, have called for increasing light to be thrown onto the shadows. But shadow banking has led to some very positive results in emerging markets such as China. By providing retail investors with a place to park their funds and by loaning to borrowers smaller than the official state policy allows, shadow banking is paving the way to market liberalization as the economy transitions from strict state ownership and control to a broader focus.
Why it’s important now
The stakes are particularly high as China’s growth rate slows from the double-digit pace of the 2000s. “Finance is not that important when growth brings in its own funds,” Franklin Allen, a professor of economics at Imperial College London and the University of Pennsylvania, said at The Fourth Symposium on Emerging Financial Markets: China and Beyond, held in May 2015 at Columbia Business School.
But as China’s growth engine shifts from state-owned enterprises to small, private businesses, new financing rules and mechanisms must come into play. “If the Chinese government can reform the formal financial sector to allow adoption of some shadow banking practices, GDP could again grow at 13 percent,” predicted Allen.
What the future holds
Shadow banking as we know it in China may be a fairly short-lived phenomenon as banks reform their lending practices to more closely resemble those of shadow lenders and as the government rejiggers banking regulations. As practices gain credibility, shadow banking products are more likely to join the official economy.
Wei Jiang is Arthur F. Burns Professor of Free and Competitive Enterprise in the Finance and Economics Division, and the Director of Chazen Institute of International Business at Columbia Business School. She is also a Scholar-in-Residence at Columbia Law School, and a Senior Fellow at the Program on Corporate Governance at Harvard Law School. Professor Jiang received her B.A. and M.A. in international economics from Fudan University (China), and Ph.D. in economics from the University of Chicago in 2001 after which she joined Columbia Business School. She has since taught courses in Corporate Finance and Corporate Governance in the Master, MBA/EMBA, or Ph.D. programs at Chicago, Columbia, Wharton, and Berkeley.