An Equilibrium Model of Entrusted Loans

Abstract

Entrusted loan is a type of inter-corporate loan and a major component of shadow banking in China. In a model with entrepreneurial moral hazard and bank moral hazard, entrusted loans arise endogenously when the banking sector is highly competitive. Entrusted loans involve a lending chain in which high-capitalized firms channel bank loans into medium-capitalized firms. High-capitalized firms obtain cheap bank loans and over-borrow to form shadow banks with the extra capital. Medium-capitalized firms simultaneously borrow from both banks and shadow banks, while low and semi-highly capitalized firms borrow only from banks. As a result of lower bank monitoring, entrusted loans improve the total welfare of banks and firms. However, entrusted loans destroy firms’ value because firms earn reduced expected profits. Default risk is increased and real efficiency reduced. The model can explain the rapid growth of entrusted loans in China since the economic stimulus plan of 2009-2010: credit expansion policies drive up the competition of commercial banks and further trigger the growth of entrusted loans.

Keywords: Shadow Banking, Entrusted Loans, Moral Hazard, Corporate Structure

JEL Classification: G21, G28, G32, G38