Emergence of Shadow Banking in China JOHN POWERS 12/9

Abstract of Report  Examines the emergence of China’s shadow banking institutions  Fundamental and structural reasons behind the growth of shadow lending in credit markets  Accuracy of risk modeling methods  Determination that risks may be overstated due to relative size of the economy and unique structure of financial system

Introduction  Traditional Banking: Commercials banks, mortgages, business loans, student loans, lines of credit etc.  Fractional Reserve Banking: Emergence of Central Banks in 1600’s.  Reserve requirements developed. Lender of last resort role established.  Heavily regulated but successfully regulated.

Shadow Banking  “Shadow Bank” term coined by economist Paul McCulley in  Refers to lending by non-bank financial intermediaries.  Not subject to traditional banking regulations.  Credit expansion driven by complex financial instruments, business to business lending, securitization vehicles etc.

Inherent Risks Revealed  Innovation allows for expansion of credit not hindered by Central Banks, traditional bank regulation  Extraordinary complexity in financial instruments  Important role in 2008 Global Financial Crisis  Inadequate Risk Modeling  Financial Contagion and lack of lender of last resort

Emergence in Chinese Economy  1978 reforms by Deng Xiapong started process the economic reforms.  Second stage of reform in late 1980’s  Mono Bank -> Multi-tiered Banks  1995 Charter for People’s Bank of China  Monetary Stability, Banking Supervision, Oversight of Payments System  1999 Commercial Lending outside of government interference (formally)

Motivations for Lending  Specialization, innovation, regulatory arbitrage  Not burdened by central chain of lending  Tight regulatory measures on commercial banking, lending, and scope of access in China.  Large populace unbanked  Social, economic and technological advancement outpacing Chinese Financial System

Lending vs. Lending Target (Seminar, 2013)

Trust Asset Growth (Seminar, 2013)

Instruments  Wealth Management Products, Trusts, Off Balance Financial Transactions

Risk Modeling  Extremely difficult because of complexity of instruments and system of delivery  Trial and error method  Constantly evolving system  Sectors cannot be isolated from systemic risks  Transparency an important component

Risks Overstated Near Term  Chinese economic makeup fundamentally different than Western Economies  High Savings Rates  Relative Complexity of Instruments  Unbanked Populace  Tight Regulation  Economic Inequlity

Conclusions  Expansion of credit needed for much of the populace  Shadow Banking may fill an important role that tight regulation creates  Risks may be overstated for the near future  Reforms in Traditional Banking System still needed.