Why the real shadow banking risks are in the US and Europe, not China

In August, the Financial Times reported that 11 Chinese shadow banks had written an open letter to the top party official in Hebei (河北) province asking for a bailout. Soon afterwards, Foreign Policy magazine ran a story headlined, “Shadow banking is killing China’s stock markets.” And, just days ago, the Wall Street Journal reported that Chinese banks are “looking to shadow banking for growth”, which is contributing to new risks.

The common denominator here is that China’s shadow banking poses a risk to the world. Yet, international data shows very clearly that shadow banking risks involve mainly the largest advanced economies.

Shadow banks perform similar functions and have similar risks to traditional banks but operate outside the formal banking sector and with less regulatory oversight. While they lack public deposit insurance and lender-of-last-resort facilities from central banks, they may support economic growth by making financial services more affordable and more broadly available.

READ MORE: Shadow banking boom pushes China to edge of debt sustainability

Modern shadow banking began in the US in the early 1970s. In an era when deposit rates were still controlled by the US Federal Reserve, money market funds provided an alternative to bank deposits. In the 1980s, the crisis involving US savings and loan institutions was essentially a shadow-banking crisis. In the following three decades, excessive deregulation and privatisation almost wrecked the international economy.

China has certainly not been spared the excesses of shadow banking, which began to grow rapidly amid the global financial crisis in 2008-09, when Beijing launched its massive US$586 billion stimulus package. While it supported Chinese and global growth for several years, pressures soon mounted, pushing business from banks toward shadow banks, which were not subject to the same limits on loan or deposit rates, by caps on bank lending volumes, or by other limitations.

By 2011, local government debt was already under scrutiny from national regulators. As new leadership took charge in Beijing, the momentum of debt-fuelled growth was eclipsed.

In mid-2013, China’s banks drifted to a liquidity crisis, but the People’s Bank of China no longer injected additional funds or eased monetary policy. A year later, it urged commercial banks to control credit-fuelled risk by increasing scrutiny of shadow banks’ lending practices.

In China, shadow banking remains less important than formal banking as a source of credit, however. Moreover, thanks to Beijing’s low debt-to-GDP ratio, authorities also have the fiscal capacity to deal with a large crisis.