Coming out of the Shadows Go back »

2012-10-30 | All chapters

Since the collapse of banks in the United States and Europe triggered the global financial crisis, the "shadow banking system" has been regarded as something of a ghost. From a legal perspective, it is not real banking system, but it possesses almost all the financial and credit functions that banks have. At the same time, it enjoys looser supervision.

In other words, the shadow banking system offers higher leverage and returns with lower costs, something that is attractive to many financial institutions. But it is also vulnerable and dangerous in the eyes of regulators.

The shadow banking system was born out of need. As China's balance of payments surplus has declined since the onset of the financial crisis, the development of the real economy has increasingly relied on the financial system to supplement liquidity.

Liquidity in the real economy is reliant on credit. For instance, in 2004, 5 yuan out of every 10 yuan added to the real economy came from credit. In 2012, the figure was 8.5 yuan. However, tighter supervision has restricted banks' capacity to expand credit, meaning the liquidity demands of the real economy are not being met. This creates room for the development of non-bank financial intermediaries, such as off-balance sheet businesses, hedge funds and money market funds.

Also, the shadow banking system always grows fast while interest rates are being liberalized because fiercer competition forces banks to seek alternative sources of profit apart from traditional banking services.

The shadow banking system in the United States has grown larger than the commercial banking system, although the market value has fallen to US$ 15 trillion since the financial crisis from the previous high of US$ 20 trillion. China's shadow banking system has witnessed rapid growth during the crisis period, but the market remains small.

Commercial banks still control more than 85 percent of China's financial assets, while the shadow banking business is mainly affiliated with the banking system.

Most of China's shadow banking system is the capital pool of wealth management products, which mainly comes from bank deposits. This is a major difference from the shadow banking system in the United States, which largely consists of capital from money market funds and is operated by specific institutions in the form of securities.

Shadow banking is like a sword; the key issue is how to use it. It shouldn't simply be rejected because of supervision failures. Of course, there are risks, but they can be managed.

The first step in supervision is to separate effectively shadow banking from the banking system to better monitor and identify risks. It is also helpful to make customers aware of dangers.

In addition, establishing a unified platform for asset transactions and trusteeship would improve the collection of information and improve transparency. It would also improve supervision of leverage changes and monitor liquidity. In terms of transparency, the financial market is always more reliable than banks' balance sheets.

Source: Caixin