Abstract
Shadow banks are broadly as nonbank financial institutions that engage maturity transformation (McCulley, 2007). The broad areas of shadow banking intermediation include: maturity transformation, credit risk transfer, liquidity and leverage. The shadow banking in China is composed of the following three distinct qualities. First is liquidity transformation, high leverage and credit transformation. The second outstanding feature is the limited regulation which does not spell out capital requirements, provisions for loan losses and the ratio of loan to customer deposits. The final characteristic is the existence of their interconnections with other institutions which makes them a source of systemic risks. (Yan and Li, 2014)
In order to contain the risks that come with shadow banking, the China Banking Regulatory Commission (CBRC) put in place a number of policies to regulate the activities of the shadow banking institutions. To begin with, the regulator raised the required reserve ratio (RRR). In addition, the CBRC initiated controls on credit and interest rates. The shadow banking industry thrive on the need for flexible funding and borrowing. The growth of the shadow banks has also led to economic growth (GDP) in China since the institutions fund small and medium enterprises. It’s recommended for the government to establish mechanisms to measure the size, location and severity ranking of the risks that the shadow banking system portend to the economy. With the data and tight control measures and policies, the economy can be cushioned against the threat of collapse.
Introduction
The idea of shadow banking was raised in 2007 by an economist Paul McCulley. He defined shadow banks as nonbank financial institutions that engage maturity transformation (McCulley, 2007). The broad areas of shadow banking intermediation include: maturity transformation (where the shadow banks source for short-term funds and put into longer-term assets), credit risk transfer (where the shadow banking entities transfer the loaning risk of the loan owner to another institution), Liquidity transformation which involves liquid cash, as well as leverage. They are called shadow banks because they try to do what the banks do.
The Financial Stability Board (FSB) positions them as credit intermediation institutions that carry out their activities external to the regular banking system (FSB, 2013). The People’s Bank of China goes ahead to list the activities as provision of liquidity transformation, maturity transformation and credit transformation. It is important to note that the definition of this broad term varies from institution to institution and country to country. Since the shadow banks are operating outside the confines of regular banking system, there are systemic risks that come with such a system of operation. The risks are mainly the comparatively low levels of securities and control.
Discussion
The business model for the shadow banking system is as depicted in the figure below. The diagram details the flow of finances from the funding source to the last beneficiary.
The current approximate value of shadow banking assets in China is 22.5 trillion RMB (FGI, 2012). The percentage proportion was rated at 43%. This figure was 53% and 51% in the year 2013 and 2014 respectively (FGI, 2015).
The shadow banking in China is composed of the following three distinct qualities. First is liquidity transformation, high leverage and credit transformation. The second outstanding feature is the limited regulation which does not spell out capital requirements, provisions for loan losses and the ratio of loan to customer deposits. The final characteristic is the existence of their interconnections with other institutions which makes them a source of systemic risks. (Yan and Li, 2014)
The most important aspect of a banking system is security which comes with accountability and regulation. It is extremely difficult to establish the magnitude of shadow banking system in a given economy since there is limited regulation and reporting. The main sources of shadow banking risks in China comprise ever-greening, moral hazard and risk bundling. Investors always want to know the activities of their investment institutions. They need assurances on their funds. In cases where the investment activities are blurry, the investors might be forced to pull out their funds. Such withdrawals led to the global financial crisis. The shadow banking institutions have very blurred information on the value of their assets, poor controls and governance, and limited access to formal liquidity.
Source: China Trustee Association-Statistics
In order to contain the risks that come with shadow banking, the China Banking Regulatory Commission (CBRC) put in place a number of policies to regulate the activities of the shadow banking institutions. To begin with, the regulator raised the required reserve ratio (RRR). In addition, the CBRC initiated controls on credit and interest rates. The shadow banking industry thrive on the need for flexible funding and borrowing. The growth of the shadow banks has also led to economic growth (GDP) in China since the institutions fund small and medium enterprises.
It is a fact that most small and micro-finance enterprises are relying on shadow banks for financing. In most economies, China included, the SMEs have resulted in economic growth. In addition, the fact that the shadow banks have taken over more risky types of loans away from the bank books makes the regular banking better protected. The flexible financing terms and comparatively favorable conditions offered by shadow banks have resulted in many businesses opting to be financed by shadow banks as opposed to regular banks. The shadow banks have a higher leverage in terms of debt versus liquidity ration. The implication is that the shadow banks have a huge return but not without the pain of enormous size of risk.
The laws that have so far been formulated to control shadow banking institutions are fewer than those that govern regular banking systems. Regulators are faced with a challenge in handling the shadow banks since they had been left to brood and grow. As a result of the growth, shadow banks are currently worth billions of RMB in China. Such a big chunk of economy needs to be handled with care. The end result is that shadow banks have a high ratio of debt to liquidity. The other evidence of lack of regulation is the fact that limited data about shadow banking institutions is available. The rule of the thumb in regulation has always been, “You can’t control what you can’t measure.” The regulator has not been able to effectively capture the statistics in the shadow banking system.
Conclusion and Recommendation
In order to address the systemic risks that come with shadow banking, there is a great need to monitor the risks. This monitoring involves data-based reports on potential risks. The data needs to capture the size of the risks, the severity of the risks and the location of the risks.
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http://www.xtxh.net/xtxh/statisticsEN/index.htm
http://www.pbc.gov.cn/publish/english/958/index.html
http://www.financialstabilityboard.org/policy_area/shadow-banking/
