Implicit Guarantees and the Rise of Shadow Banking: The Case of Trust Products

Abstract

Implicit guarantees provided by financial intermediaries are important in China. We argue theoretically that project screening by financial intermediaries, accompanied by their implicit guarantees to investors, can be the second-best arrangement. It can also mitigate capital misallocation that favors state-owned enterprises (SOEs). Using a comprehensive set of trusts’ investment products, we find, consistent with our model, that ex ante expected yields reflect borrower risks and implicit guarantee strength, and risk sensitivity is reduced by strong guarantees. Regulations in 2018 restricting implicit guarantees lead to a weaker relationship between yield spread and guarantee strength, and more credit rationing of non-SOEs.

Keywords: Shadow banking, trust products, implicit guarantee, yield, real estate, SOE

JEL Classification: G2, G3, L2