Optimal Shadow Banking
55 Pages Posted: 20 Apr 2021 Last revised: 7 Oct 2022
Date Written: October 6, 2022
China’s shadow banking system has experienced surprisingly high growth since the global financial crisis. We develop a model to understand this puzzling phenomenon. With local government interventions in bank loans for low-quality projects and information asymmetry between banks and regulators, a policy combination of tightening formal banking and loosening shadow banking can reduce inefficiency, because the higher funding liquidity risk of shadow banking incentivizes banks to be more disciplined about the quality of projects. We find consistent empirical evidence that when on-balance-sheet financing was constrained by regulators, banks primarily shifted high-quality projects into their controlled shadow banking system.
Keywords: Shadow Banking, Information Production, Moral Hazard, Bank Regulation, Financial System in China
JEL Classification: E40, E50, G20
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