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

Abstract

The shadow banking literature is anchored on the premise that shadow banking intensifies financial risks through its connection with regular banks. We document the importance of implicit guarantees as the risk transmission channel using a detailed micro-level data set on wealth management products, which are the most prominent shadow banking products in China. We find that when the risk perception of a bank increases, the bank extends stronger implicit guarantees to the investors of wealth management products to safeguard its reputation. Stronger guarantees incur more expenses and erode bank equity, thus amplifying impacts of negative shocks to the related regular banks. The expenses account for a significant reduction in bank profits, especially for banks that are less healthy. Our results suggest that risk-weights for off-balance-sheet exposures should be higher for riskier banks.

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

JEL Classification: G21, G23, G28