ChineseFinancial and Monetary System
InChina, shadow banking has become a significant system and has beenconsidered part of Chinese finance. The Financial Stability Board(FSB) refers shadow banking as a credit intermediary that involvesentities, as well as activities, which are deemed to be outside theusual banking system. The shadow banking system, in China, is viewedas a credit intermediation that offers liquidity and credittransformation, although it operates outside the normal bankingsystem. In the Chinese market, shadow banking exists in various formsand has different impacts on the development of the financial system.The origins and growth of shadow banking emanates from the continuousactivities of the financial market. It can be argued that shadowbanking has partly triumphed in mitigating borrowers’overdependence on banks, developed more investment opportunities, andmet part of the economy’s capital demand. The system can also beindicated to have enhanced liquidity and activity in the financialmarkets of China (Elliott et al., 2015). Furthermore, it has helpedin making investment/lending more efficient. The purpose of thisreport is to discuss the varied forms of shadow banking activities inChina, their impacts on the financial system development, thepotential perils of the shadow banking system, as well as thechallenges faced by the Chinese authorities in the regulation of thesector, and the recommendations on what can be done to reduce thechallenges posed by the sector without necessarily hurting the upsideof the system.
TheMain Forms of Shadowing Banking Activities in China
Guarantees
Inthe Chinese market, guarantee entities have their operations inshadow banking in two ways. First, they engage in the centralbusiness of offering financial guarantees through the transfer ofcredit risk to the guarantee firm (Elliott et al., 2015). This hasthe advantage of mitigating capital needs for banks that make suchassured loans. Also, the guarantee entities give direct loans even ifthey do not hold legal certificates to engage in the activity.
Bankers’Acceptances (BA)
Bankers’acceptances are permits that are issued by banks that offer anagreement to make payment in the future unconditionally, which isusually within a period of 6 months. The BAs are usually backedpartly by a deposit that the party desiring issuance of bankers’acceptance makes. In this case, the deposit acts as collateral.
TrustLoans and Leases
Theseare financial dealings that are assumed by trust companies. A trustentity is a firm that is separately regulated and combines aspects ofbanks, as well as resource managers, in Western monetary systems(Elliott et al., 2015). These entities have broad latitude inoperating across the fiscal sector however, guidelines areprogressively tightening restrictions on their activities.
FinancialLeasing
Leasingservice is also an activity supported by shadow banking. This entailsleasing of different forms that do not exist in banks. The financialleasing is not offered for a short duration, and some of it may beoffered by specialty leasing entities.
MicrofinanceCompanies
Microfinanceentities are considered to be firms that are separately regulated anddeal with the provision of financial services. However, theseentities have permits to provide credit in small volumes, which aidin encouraging small businesses and rural borrowers to access credit.Therefore, it can be argued that the microfinance companies act astargets for small businesses and rural households.
WealthManagement Products
Wealthmanagement products entail commodities that offer a yield on theground of the performance of several basic assets. Basically, theoriginal investment is a single vast loan. Wealth management productsare provided by banks or trust entities however, securityorganizations provide similar products (Elliott et al., 2015).
EntrustedLoans
Entrustedloans are types of credits made by organizations in the non-fiscaleconomy, which are operated via banks for legitimate purposeshowever, the banks are covered from the loan risk of the debtorthrough the non-fiscal organization (Elliott et al., 2015).
BondMarkets
Sometimes,the commercial bond market is incorporated in obtaining shadowbanking volumes, although the normal definitions in the globe do notsupport the inclusion of bonds in the calculations.
PawnShops and Unofficial Lenders
Theseshops are considered vital creditors to some households as well asmeager businesses. Besides, there are other creditors that tend torun informally to friends, relatives, or close associations. Althoughsome informal lending has been termed illegal, they cannot bebelieved to have a high percentage in shadow banking (Elliott et al.,2015).
Impactsof Shadowing Banking on the Development of Financial System
Theshadow banks have been indicated to have both positive and negativeimpacts on the development of the financial system. Although thereare two sides of the system, it can be indicated that the positivepart of the shadow banking exceeds the negative side. The Chineseauthorities need to put some regulations that would help ineliminating the adverse effects of shadow banking, which would aid inenhancing the efficiency of the system. The following paragraphs willdiscuss the adverse and positive effects of shadowing banking on thefinancial system development.
PositiveImpacts
Oneof the positive sides of shadow banking is that it can aid in fuelingeconomic growth through making financial services less expensive, aswell as widely operating accessible. Compared to the normal bankingsystems, the shadow banking system is considered to have loweroperating costs (Zhang et al., 2014). The low operating costsfacilitate the shadow banks to provide loans and other financialservices at a reduced price. Through providing cheaper loan andfinancial services to the citizens, the system is in a position toreach a large number of people a move that can help in thestimulation of finance scheme in the country. Another positivebenefit of shadow banking is that it is capable of providing servicesthat regular banks cannot offer or serving customers that would notserve. For instance, shadow banks have the ability to provideservices of entrusted loans, a service that cannot be offered by theregular banking system. This is an important consideration since itis an important ingredient towards financial development since theservices that clients obtain in the shadow banks would play a part,in one way or another, in building the financial system.
Shadowbanking plays a critical role in the growth of the financial sectorbecause it is believed to provide more resources to the SMEs. Because of its flexibility, the shadow banking system has thecapacity of offering services to small and medium enterprises inlarge numbers. Most of the SMEs are not in a position to obtain loansand other services from the regular banking systems due to the strictregulations that guide the banks in the provision of services (Zhanget al., 2014). The SMEs usually form a large contribution to theeconomy through boosting the economy, enhancing innovation,increasing employment level, and export expansion (Check appendix a)check appendix b for SME and exports in China. Through thesecontributions of the SMEs via the shadow banks, it can be argued thatshadow banking provides a favorable financial environment, which iscritical in the growth of the financial system.
Furthermore,shadow banking has positive impacts because it permits borrowers tobe in a position to obtain resources from a broader range ofinvestors having a broader pool of peril preferences. The capacity oftransforming cash flows from fairly illiquid resources such as longrun individual credits into liquid, diversified, tradable securitiesthat profit investors concerned in holding securities, which offer areturn and may be transformed into cash easily. The capacity ofshadow banks of customizing securities permits the development ofrisk-return compromises which are appealing to all kinds of savers.Demand deposit commodities provided through the regular bankingsystem conventionally never provided the scope of risk-returngroupings availed to the marker-mediated credit. However, the shadowbanking system has helped in fueling a vast increase in the amountsof available credit. The build-up of credit to the borrowers is acritical aspect in the development of financial system (Elliott etal., 2015).
Inaddition, another positive impact on the growth of the financialsystem is that shadow banking brings possibilities for profits fromspecialty by loan providers, including superior knowhow originatingfrom specialism in a single field of the market, as well as economiesof scale, made feasible by focusing on certain credit arbitragefunctions. Companies operating in the non-bank field and creditguarantors may specialize in niche areas, which are not well-servedby regular banks. In such an instance, the underserved area by thebanks would be in a position to generate incomes through the servicesof the shadow banks, which would help in the development of thefinancial system.
NegativeImpacts
Despiteshadow banking having a positive impact on the development offinancial system, it also has adverse effects on the financial systemdevelopment. One of the negative impacts on the growth of thefinancial system is that it offers loan services to riskier customersor in riskier forms. For instance, it is in a position to give outloans without collaterals. Through giving out unsecured loans toindividuals, shadow banks have a higher probability of losingresources. The loss of resources borrowed from the shadow banks isconsidered a financial loss since the resources could have beeninvested in a more gainful manner in case strict laws were provided.Thus, instead of expanding the financial system, it leads to itsdeterioration.
Also,shadow banking has been considered to increase financial fragility.Although it has been believed that securitization as well as shadowbanking can enhance financial stability through better allocation ofcredit risk across different investors, shadow banking increasesfinancial fragility emanating from the off-balance-sheetassociations. It is difficult to trace the balance sheet of a shadowbanking system the invisibility of the occurrences is questionableto the growth of the financial system.
Moreover,due to the attractiveness of the shadow banking in its services forinstance, offering loan and other services at a reduced price, mostcustomers may prefer running from the regular banking systems so thatthey can obtain the services of the shadow banks. In such a move, theregular banks would have a reduced number of clients, which wouldaffect the contribution of regular banks in the growth of theeconomy. Such a move has resulted in the limitation of the expansionof the financial system.
PotentialRisks of the Shadow Banking System
Emanatingfrom the spread of shadow banking in the Chinese market, the keyquestion that comes to mind is whether it poses severe risks inChina. Certainly, there are significant risks that the shadow bankingsystem has in China due to various reasons such as the business isriskier compared to regular banking, operates with meager safetymargins, there is little transparency in the system, China isundergoing some hard adjustments economically which could triggerloan losses, and shadow banking has too much reliance on implicitguarantees. The following paragraphs discuss the potential risks thatthe shadow banking system poses in China.
Oneof the main risks in shadow banking originates from maturitydisparities amid funding sources, especially WMPs, and risky loansthat end up in risky sectors like coal mining and poverty development(Liang, 2015). The moment trust entities run into solemn cash-flowproblems, the evasions they make on WMPs are aching, but usually notshattering. Predictable contagion to the Chinese financial scheme islimited. However, the bet would be wrong in case there would be ashadow banking crisis in China (check Appendix c for percentage ofWMPs).
Besides,shadow banking system has been deemed to mitigate the effectivenessof macro-prudential controls, as well as financial supervision. Someof the institutions associated with shadow banking invest in propertyentities, high-pollution sectors having excess production capacity,which interfere with macro-prudential controls and impact the rate ofeconomic adjustment. This poses a risk to the economy since there islikelihood that there would be less concern in the control of issuesthat can adversely influence the performance of an economy.
Anotherrisk that may emerge as a result of the shadow banking system isfinancial instability. This risk lies in the possible defaults thatare likely to be there by the local governments, which may begenerated by the economic go-slow as well as deteriorating landprices (Liang, 2015). Most local regimes are usually over-influencedand much of their debt is under the ownership of front entities,through shadow banks. In mitigating the peril of local governmentevasions, the central administration has introduced a policy thatallows local regimes to issue bonds for the substitution of debt. Incase the bonds are to be obtained from the shadow bank system, thereis likely to be a financial instability.
Inaddition, another risk that may emerge emanating from shadow bankingis the deceleration of the economy. Because of the cheaper ratesoffered by the shadow banks, for its services, there is likely to behuge amounts of resources given out by the shadow banking system.However, since the guarantee for returning the loans taken byindividuals and firms is very low, most of the resources do notbenefit the economy since they go to unproductive activities orprojects. Channeling of resources to unproductive products can resultin the deceleration of the economy.
Therealso exists a risk to the regular banking institutions. Shadowbanking has been considered to have serious implications for normalfinancial institutions, which affect them mightily. Some of the gainsfrom shadow banking are deemed to be unreasonably high a move thatoffers a false incentive for customers, unleash unjustifiableaggression, as well as threaten to steal business from the normalfinancial institutions (Liang, 2015). These implications tend toinfluence regular banking institutions adversely, which may create anenvironment that is unfriendliness and redundancy, despite theinstitutions operating in the same industry. Such a move may resultin customer suffering because they may not obtain what they desire.
Furthermore,shadow banking poses a great risk, not only to the financial area,but also in other areas. Some of the shadow banking firms are notregulated appropriately, a move that has made them expand recklesslyhaving little concern on risk management. Ignoring the management ofrisks can be seen as an eminent danger because it disregards thesafety and well-being of customers. Besides, the government units donot supervise the daily activities of these organizations, which maypresent an excellent ground for problems in the area of business, aswell as fields, in which customers operate.
Actionsthe Chinese Authorities Have Taken To Address These Issues
Giventhe expansion of the shadow banking, the authorities started to worrydue to its impacts. There were two great concerns on the side of theregulators: first, they were worried that an uncontrolled shadowbanking sector could generate extreme credit progress and second, alack of openness in the utilization and source of resources couldgenerate concealed perils. Therefore, the authorities focused onthree actions decelerating the speed of non-bank credit expansion,applying discipline on the utilization of the inter-bank market forfinancing, and necessitating the arrangement of shadow assets, aswell as liabilities, to be made open (Bottelier, 2015). The followingparagraphs discuss these actions.
Deceleratingthe Speed of Non-Bank Credit Growth
Throughthis government intervention, virtually all the credit for expansionin 2012 and part of 2013 was from sources other than bank lending.The monetary tightening became applied by the government in 2013 camealmost to a time that there was a deceleration in the pace ofnon-bank lending that brought growth in entire credit down to below15%, while there was virtually no change in the speed of bank lending(Bottelier, 2015).
ApplyingDiscipline on the Utilization of the Inter-Bank Market for Funding
Disciplineon the inter-bank market commenced in June of 2013, when the PBOCcame up with a liquidity squeeze, which temporarily drove overnightinterest rates to approximately 30%. The panic that resulted infinancial markets coerced the PBOC to backpedal temporarily, but overthe rest part of the year, inter-bank and other short-term fundingrates rose gradually (Bottelier, 2015). One of the primary reasonsfor this action was to curb the enthusiasm of smaller banks, whichhad been borrowing large amounts on the inter-bank market, so as tofund higher risk lending activities that were routed through shadowbanking. The PBOC did not sufficiently communicate its objectives,and markets were temporarily unsettled as a result however, theregulatory intention was sensible and straightforward.
Transparencyof Composition of Shadow Assets and Liabilities
Thedetermination of making shadow banking activities more transparentare incorporated in different regulatory documents such as the StateCouncil’s Document N0. 107 and No. 127 and CBRC’s Document No.140. According to Document 107, the action of fund pools is banned,where trust entities and other WMP issuers cannot move resourcesextensively from one venture to another. Also, institutions arerequired to have a limit on their experiences to individualcounterparties, as well as meet capital necessities for off-balancesheet transactions that did not require to be backed by capital.
ChallengesFacing the Chinese Authorities in Regulating Shadow Banking Sector
Thereare different challenges facing the Chinese authorities as they tryto regulate the shadow banking sector. One of the challenges is thehigh capacity of implicit guarantees throughout the system. It isdifficult to entirely eliminate implicit guarantees because they tendto arise whenever there is the belief that another party can step into bail out an institution or transaction even when the allegedguarantor has made no such promise. Nevertheless, implicit guaranteestend to fade away the moment there are plausible and explicitguarantees or other mechanisms which define what would happen in casethere emerged trouble. Unwinding implicit guarantees is exceedinglydifficult, especially in the country. It is not adequate to simplyindicate that the guarantees no longer exist because the investorshave to see a likely mechanism by which the presumed guarantee canfail to operate.
Apartfrom implicit guarantees, there exists the query of the lender of thelast resort, which is a function of the central bank. Vividly, thePBOC would offer emergency funding to a solvent bank that faces aliquidity crisis. Nevertheless, the PBOC would step in when a vasttrust company or other form of shadow bank has the same problem. Thesolution to this vital question is not clear, and may result invarious issues. The worst case would be if a trust entity or itsfunders presume that the PBOV would get involved and then the fundersencounter losses when the assumption turns out not to be true. Thiscan result in a crisis.
Anotherchallenge entails failure of having an entirely integrated regulatoryframework. Financial institutions are usually involved in a broadrange of businesses directly, through subsidiaries, or throughcooperating with independent organizations such as shadow banks.However, the regulatory system of China comprises of PBOC, CSRC,CBRC, CIRC, and other agencies. This generates regulatory gaps, aswell as loopholes, which financial institutions can arbitrage infinding the kindest treatment.
Besides,a lack of transparency is also an issue when it comes to theregulation of shadow banking system. Since most of shadow banking isa type of regulatory arbitrage, there is an aspect of opacity or evenmisdirection in transactions made. The opacity of the shadow bankingsystem makes the regulations from authorities more likely to fail ordifficult. To make it worse, in a crisis, it can result in panickingsince perceptions of the actual strength of a bank or other financialagency can fall sharply because investors and depositors recognizethat they do not understand what the balance sheet groupingrepresent.
Moreover,in the regulation of shadow banking, another challenge that isencountered is regulatory inconsistency. There are varied,inconsistent reports about regulators permitting or turning a blindeye to actions that are not authorized, openly not allowed, or evenillegitimate. Part of this is arguably benevolent in that it is akind of the classic Chinese technique of the reform era of takingsmall steps and learning about them as one proceeds (Sheng & Ng,2016).
Proposalsto Reduce the Downside without Hurting the Upside of Shadow Banking
Thereare various proposals that can be put forward in reducing thedownside of shadow banking while maintaining the upside of thesystem. One of the proposals is that the banking system needs toexpand the financial services to SMEs, households, and ruralbusinesses. The SMEs have a difficult time obtaining resources fromthe regular banking systems, which is the same case to ruralbusinesses and households. However, the shadow banking system is in aposition to offer loans to these units with ease a move thatgenerates a high demand for resources from shadow banking system.This has the risk of causing the destabilization of the economy,despite the potential benefits it holds to the economy. In an attemptto correct and regulate the downside that can be brought by havingshadow banking providing a lot of resources to the SMEs, householdsand rural businesses, it is recommended that the regular bankingsystem should increase the amounts it channels to these units(Elliott & Qiao, 2015). Such a move would help in reducing thehigh demand for resources from shadow banking system, which wouldcreate stabilization in the economy.
Anothercritical proposal that can be considered in an attempt to correct thedownside of the shadow banking system while preserving its upside isincreasing the efficiency of the financial sector. Reforming of theshadow baking system must encourage firms to become better providersof services to their target market compared to the regular banksthis would spur regular banks to enhance their businesses. In thiscase, efficiency entails offering services that are tailored to theneeds of customers, at a favorable price, and when needed (Elliott &Qiao, 2015). Thus, enhancing the efficiency of the system would meana lot to resolving the issues associated with the shadow bankingsystem.
Besides,striving for a level playing ground across the financial sector canbe proposed as another way of ensuring that the downside of shadowbanking system. An important way of achieving a more efficient, aswell as safer financial system, which includes shadow banks entailsstriving to ensure that varied financial sub-sectors contend on alevel playing ground. In short, China needs not influence thesub-sectors that win or lose the market share through implicitsubsidies or generating regulations that create advantage on onesub-unit at the expense of others (Sekine, 2015). If it is oneregulation that the authorities desire to provide for the benefit ofthe sector, then the regulation should be for all the firms in thesector. Thus, through helping shadow banks play a level field justlike the normal banks would help the system in eliminatinginefficiencies that it possesses. Currently, regular banks and shadowbanks function under exceedingly different guidelines that offer themunique combinations of benefits, as well as costs. These guidelinestend to create a crisis in the financial sector.
Furthermore,increasing consumer opportunity, as well as safety, would be animportant proposal for the proper functioning of the system. One ofthe initial shadow banking commodities to emerge in China was thewealth management products, which has been capable of servinghigher-yielding substitutes for bank deposits, at the same time,being viewed as being essentially safe like deposits (Sheng & Ng,2016). Therefore, this part of shadow banking offers an instantconsumer benefit. In the shadow banking system, part of the lendinghas gone to small businesses and households, offering them resourcesthat they could otherwise not obtain (Elliott & Qiao, 2015). Thecharges have been higher compared to those for corporate borrowinghowever, the rates are still attractive to individuals without othernoble alternatives. The shadow banking should not consider increasingtheir rates, but should focus on expanding the benefits further tomore customers. Besides, reforms need to emphasize on improving thesafety of consumers, especially by ensuring that buyers understandthe products and services they are purchasing and the risksassociated with them, if any.
Inaddition, it is important to consider defining clearly the nature ofthe safety net for the firms in the financial system. One of thechallenges that make the shadow banks not function properly is thehigh volume of implicit guarantees present in the financial system.Although the implicit guarantees are difficult to deal with, there isa need for developing a safety net within the financial system. Theauthorities should make a clarity concerning which institutions areeligible for lender of last resort aid and the guidelines for theassistance should be spelt out, especially the collateral necessities(Elliott & Qiao, 2015). Furthermore, the authorities need tostress on the necessity of having clarity in the financialassociations, especially the guarantees, amid financial institutions.This must be confirmed, backed by law and guidelines, or investorsshould be convinced that it is not the case.
Conclusion
Theshadow banking system, in China, is viewed as a credit intermediationthat offers liquidity and credit transformation, although it operatesoutside the normal banking system. In the Chinese market, shadowbanking exists in various forms and has different impacts on thedevelopment of the financial system. From the discussion, it can beargued that shadow banking has partly triumphed in mitigatingborrowers’ overdependence on banks, developed more investmentopportunities, and met part of the economy’s capital demand. Thesystem can also be indicated to have enhanced liquidity and activityin the financial markets of China. Furthermore, it has helped inmaking investment/lending more efficient. There are significant risksthat the shadow banking system has in China due to various reasonssuch as the business is riskier compared to regular banking,operates with meager safety margins, there is little transparency inthe system, China is undergoing some hard adjustments economicallywhich could trigger loan losses, and shadow banking has too muchreliance on implicit guarantees. The risks associated with shadowbanking system include financial instability, deceleration of theeconomy, mitigates the effectiveness of macro-prudential controls,and influencing the regular financial institutions. Differentproposals can be made that can help in correcting the downsides ofthe shadow banking system these include defining clearly the natureof the safety net for the firms in the financial system due to theimplicit guarantees that make the shadow banks not function properly,increasing consumer opportunity and safety, striving for a levelplaying ground across the financial sector, increasing the efficiencyof the system, and expanding the financial services to SMEs,households, and rural businesses. From the analysis, it can be arguedthat shadow banking has positive benefits, but it still poses athreat emanating from its nature. Therefore, there is the need forauthorities to regulate its operations in order to eliminate theperils.
Appendices
Appendixa
Appendixb
Proportionof SMEs that Exported in 2014
Appendixc
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