The Unintended Consequences of Regulation: Evidence from China’s Interbank Market

Abstract

This working paper was written by Xian Gu (Central University of Finance and Economics; University of Pennsylvania) and Lu Yun (Central University of Finance and Economics).

In this paper we use evidence from China’s interbank market to examine the unanticipated consequences of regulation on the financial system. We find that banks tend to use newly introduced and lightly regulated financial instruments in the interbank market to get around regulation in the search for funds. Specifically, we find that banks which face greater competition have engaged more heavily in the issuance of interbank negotiable CDs and interbank wealth management products, especially when market rates are high. Moreover, these interbank activities are closely associated with banks’ proprietary trading, suggesting the potential risk of contagion in the financial system.

Keywords: Interbank, Negotiable CDs, Interbank WMP, Proprietary trading

JEL Classification: G20, G21, G28