China’s struggle to control credit
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Despite the 2008 financial crisis, unregulated and under-supervised lending continues to grow around the world. Nearly 15 percent of financial assets are held by shadow banks—a catch-all term for any non-traditional, alternative banking.
Although China is a developing country with unique political and financial institutions, it too is grappling with and evaluating the costs of shadow banking.
In fact, China’s central bank appears to have lost important controls overs its financial sector between 2009 and 2015 because of shadow banking, according to a paper in the December issue of the American Economic Review.
Authors Kaiji Chen, Jue Ren, and Tao Zha argue that the half of Chinese banks that are not state-run found creative ways to circumvent lending regulations after the financial crisis. This, in turn, damaged the Chinese central bank’s ability to control the credit supply.
From 2008 to 2015, China’s central bank focused on controlling M2—physical currency, checking accounts, and other cash-like instruments—and bank lending to make sure credit didn’t grow too quickly or too slowly. But without leverage over alternative credit supplies, the central bank struggled to keep its mandate to contain inflation and maintain economic growth.
Figure 1 Chen, et al. (2018)
Panel A from Figure 1 in the paper shows the sharp growth in traditional credit (M2 and bank loans) that the central bank encouraged after the 2008 financial crisis. The drop that immediately follows shows that the central bank was successful in restricting traditional credit.
But Panel B indicates that the contraction in traditional loans didn’t stop banks from finding alternative means to lend money. Panel B uses a logarithmic scale, so the increase from 2010 to 2015 is quite dramatic. Shadow-bank lending was roughly ten times larger in 2015 compared to 2010.
In short, when the central bank tried to rein in the supply of money and bank loans, banks switched from traditional lending to shadow-banking activity.
The authors’ research shows that understanding the role that shadow banking plays in the financial system will be important for central banks to carry out their mandate to ensure stable economic growth.