Kaiji Chen, Jue Ren, and Tao Zha
Working Paper 2016-1
January 2016
Download the full text of this paper (521 KB) 
We argue that China's rising shadow banking was inextricably linked to potential balance-sheet risks in the banking system. We substantiate this argument with three didactic findings: (1) commercial banks in general were prone to engage in channeling risky entrusted loans; (2) shadow banking through entrusted lending masked small banks' exposure to balance-sheet risks; and (3) two well-intended regulations and institutional asymmetry between large and small banks combined to give small banks an incentive to exploit regulatory arbitrage by bringing off-balance-sheet risks into the balance sheet. We reveal these findings by constructing a comprehensive transaction-based loan dataset, providing robust empirical evidence, and developing a theoretical framework to explain the linkages between monetary policy, shadow banking, and traditional banking (the banking system) in China.
JEL classification: G28, E02, E5, G11, G12
Key words: Regulatory arbitrage, asset pricing, institutional asymmetry, entrusted loans, risk taking, shadow loans, bank loans, nonloan investment, nonbank trustees, small banks, large banks, balance sheet, optimal decisions