The Risk of Implicit Guarantees: Evidence from Shadow Banks in China

Abstract

Although implicit guarantees are widely used in the shadow banking system, we know very little about its qualitative and quantitative properties. In this paper, we use a micro-level data set on China's shadow bank products to quantify the risk of implicit guarantees. We find a robust empirical fact that a bank extends stronger implicit guarantees to its shadow bank debt (i.e., wealth management products) when its reputation deteriorates. A simple model based on a stylized signaling game is proposed to rationalize the fact. The key mechanism of the model is that as a bank's reputation becomes worse, it has stronger incentives to send positive signals to the market, i.e., to boost the realized returns of its shadow bank debt, although it is not obliged to do so. Our findings imply that riskier banks should have higher risk-weight for their off-balance-sheet exposure because they are more tempted to offer implicit guarantees and take losses for its off-balance-sheet operations.

Keywords: shadow banking, implicit guarantees, off-balance-sheet financing

JEL Classification: G21, G23, G28