Kaiji Chen, Jue Ren, and Tao Zha

Working Paper 2016-1
January 2016

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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

This research is supported in part by the National Natural Science Foundation of China (NNSFC) Grant Numbers 71473168 and 71473169. The authors thank Marty Eichenbaum, Sergio Rebelo, Richard Rogerson, and Zheng (Michael) Song for helpful discussions. They are grateful to Karen Zhong for her outstanding research assistance. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta, the Federal Reserve System, or the National Bureau of Economic Research. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Kaiji Chen, Department of Economics, Emory University, Rich Memorial Building, 1602 Fishburne Drive, Atlanta, GA 30322-2240, kaiji.chen@emory.edu; Jue Ren, Department of Economics, Emory University, Rich Memorial Building, 1602 Fishburne Drive, Atlanta, GA 30322-2240, jue.ren@emory.edu; or Tao Zha, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, and Emory University and NBER, tao.zha@atl.frb.org.
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