China’s shadow banking woes force regulators to change course on policy making

The sobering fact that China’s shadow banking system now contributes about one-third the country’s total credit to the real economy is a stark lesson in how well-intentioned policy can lead to a financial mess.

Mainland financial authorities have been tightening rules to better police shadow credit since the beginning of this year, part of their plan to deleverage an economy facing lofty debt levels and high risk exposure.

The new policy direction conveys a message that shadow banking increasingly appears to be the bogeyman behind the world’s second-largest economy that’s trying to make the massive transition to a slower but more sustainable growth pattern.

But in hindsight, the root cause of the explosion in shadow banking was the central government’s attempts to spur economic growth and to reform a rigid banking sector.

Shadow banking refers to institutions and markets that carry out traditional banking functions outside the traditional, regulated banking system.

The spread of shadow banking in China was the result of regulatory arbitrage under which business organisations capitalise on loopholes to circumvent unfavourable regulations.