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From: Ying Chen, Jingbo Hao, Chilin Xiao
To: Xiaochuan Zhou, President of The People’s Bank of China
Subject: Shadow banking in China
Date: April 30, 2014
Issues
The substance of shadow bank is very similar to the one of regular commercial bank.
Shadow banking institutions and business involve in the financing, which has the similar
characteristics to the deposit. Besides, they also provide liquidity support, credit support and
use the leverage in public or secretly.
There is actually a debtor-creditor relationship between shadow banking system
institutions and business. However, due to the lack of regulation in capital adequacy, loan
concentration, leveraged rate, provision and liquidity risk, market risk, operation risk, it is
possible to have the systematic risk caused by regulatory arbitrage, excessive amplified
leverage and mispricing under credit risk. Hence, this needs to be paid attention.
Potential risk
With the coexistence of the rapid development of regulatory arbitrage and financial
repression, and the background of the change from eased monetary credit policy to tight one,
the shadow banking system in China is generated by the regulatory arbitrage. To the larger
extent, it is the coexistence of “the shadow of bank” and the process of the interest rates
liberalization and the disintermediation. In general, the shadow bank is discussed as the
replacement of credit assets. Shadow bank system in China grows in a rapid rate (with a
CAGR of 140.47% in last decade) in last years, yet still a relative small portion relative to
bank loans (28%-30% of total SFA).

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AFRE Bank system Shadow bank system SBS as % of SFA
2002 20,112.00 20,201 - 0%
2003 34,113.00 30,995 2,611 8%
2004 28,629.00 25,194 2,828 10%
2005 30,008.00 27,308 1,985 7%
2006 42,696.00 36,828 5,020 12%
2007 59,663.00 46,804 11,774 20%
2008 69,802.00 59,835 8,470 12%
2009 139,104.00 120,924 15,750 11%
2010 140,191.00 101,155 35,959 26%
2011 128,286.00 98,462 25,267 20%
2012 157,631.00 116,258 36,187 23%
2013 173,168.00 115,096 51,625 30%
2014 Q1 56,042.00 39,214 15,546 28%
CAGR 21.62% 17.14% 140.47%
It is reasonable that the shadow bank exists in China. The capital hunger from the
emerging market and the tight capital market motivates banks and other financial institutions
to create financing tools to avoid the supervision from PBC. However, instead of risk free
and high profit return, shadow banking increases the systemic risk for the government credits
once the borrowers default.

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From the theoretical view, shadow-banking system can go through an unlimited credit
expansion by the monetary creation process similar to the loan-to-deposit process, which will
cause the dramatic increase in the systematic risk for the whole society if there is no limit.
When the systematic risk breaks out, shadow bank can be the weakest step of the crisis due to
the lack of corresponding liquidity risk and measures for credit risk management. In certain
circumstances, it even can be an inducement of the systematic risk.
This is mainly because the dramatic increase in the number of shadow banks has amplified the
risk of leverage in corporation and the excessive investment, especially through the implicit
warranty and the rigid payment which is the payment from own pockets, the risk-free
corporations do not reflect any information on the credit risk they actually have, which makes
the investors’ assets allocated invalidly and only pursue the high-profit assets, but the high
interest rate can only be afforded by the property and the government financial platform that do
not have budget constraint, or the zombie companies who must borrow the money to cover the
deficit to survive. Only if the rigid payment keeps going on, these programs may continue to
finance from the market, resulting in the adverse selection in the resource allocation, the
economic restructure and the innovation transformation of the whole society that cannot be
stimulated.
Options
• Marketization and transparency
The measure to control the rapid growth of shadow bank system should resolve the current
problems and eliminate the root causes, maintain a certain pace, replace the stock with the
increment gradually and avoid the sudden stop when something happens. The suggestions of
the governance to the shadow bank in China can be summarized into two words: marketization
and transparency.
Based on the transparency and effective regulation, commercial banks let up the regulation of

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the loan-to-deposit ratio and the scale of loan that gives them more market-oriented space to
operate, including the following points:
First, cancel the changeable control of credit scale in business banks. In the wake of
disintermediation, the proportion of bank credit in the total social financing has decreased to
50%. Only controlling the credit scale of banks cannot achieve the effect, but generate shadow
bank system, which is against risk management. Hence, on the premise of having the strict
regulation, the central bank should transfer from quantitative management to price management
and control the total amount of credit provided in society through the variable interest rate.
Second, adjust the loan-to-deposit ratio. Before the modification of the commercial bank law,
the bank liquidity regulation index was improved according to the diversity of bank liabilities,
while the loan-to-deposit ratio was adjusted, the stability of fund was increased and the suitable
deadline (e.g. over half year) of the inter-bank deposit was allocated.
Third, securitize and normalize the bank credit assets as soon as possible.
Fourth, accelerate the opening of bank industry to private capital and focus on the development
of private banks that provide the specific service to the small corporations, issues of agriculture,
farmer and rural area, and community finance.
To shadow bank system institutions and business, first of all, we need to admit the market
attribute, establish the market spirit of contract among investors, financiers and other related
institutions, accept the principle that sellers have the duty while buyers have the responsibility,
and gradually transfer to direct financing and formal financial market.
Then we should establish the uniform data monitoring and the coordinating system of People’s
Bank of China, China Banking Regulatory Commission, China Securities Regulatory
Commission and China Insurance Regulatory Commission in general, set up the principle
regulatory standard of capital adequacy ratio, liquidity risk and reserve ratio that is suitable to
be applied in a variety of business, avoid the regulatory arbitrage or over-regulation that may

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aggravate the financial risk, weaken the effect of regulation and the monetary policy. Moreover,
we should also keep the bottom line of the law and resolutely fight against the financial
activities that have been out of the regulation and broke the law.
Suggestion
In the general principle, shadow bank should be managed in classifications and treated
distinctively. The following suggestions are listed below to some of the large-scale shadow
banking system:
To a part of asset management products, including the bank financial products and the trust
funds, the key point of product design is to isolate the risk, estimate the risk and make the risk
affordable, which can transfer the profit and the risk of the basic assets to investors, establish
different thresholds in business and prevent the spread of risk.
Due to the characteristics of deposit and the large number of individual investors, the money
market fund has already had the ability to affect the market. As an information amplifier, the
money market fund will withdraw the deposit in the bank immediately under the pressure of
terminal investors when the liquidity risk happens, resulting in the deterioration of the bank
balance sheet. Therefore, the money market fund with a certain scale can be required to put
amount of reserve fund in the central bank or use the method of mark-to-market evaluation in
order to reflect the change of the risk.
To the financial management on Internet and the P2P business, the first thing should be done is
to act as the intermediary platform providing the information instead of as the financial entity.
Secondly, pay attention to the statistical monitoring and the information disclosure, which allow
the participants in the financial market to make their own choices.
What we still need to know is that the shadow banking system in China is the product generated
by regulatory arbitrage that is under the coexistence of the rapid development of financial

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liberalization and financial repression. The shadow banking system is combined with interest
rate liberalization and disintermediation. Besides the necessary regulation to shadow bank, we
should also accelerate the financial reform, create a liberalized and efficient formal financial
environment, and improve the capital market and bond market. While we provide more direct
financing channels to entity economy, we also provide more tool selections to investors and
reduce the effect of shadow bank from the view of financing and investment in order to
minimize the risk caused by shadow bank.