The Shadow Banking System - why it will hamper the effectiveness of Basel III and The Shadow Banking System in China

Abstract

This paper examines why regulatory arbitrage and the interconnectivity between the traditional banking and shadow banking systems amplified the pro-cyclicality during the global financial crisis of 2007-2009; and discusses why the regulatory focus should turn to reducing the interconnectedness of the two systems in order to prevent systemic risk to the global financial system. This paper also predicts that Basel III’s heightened capital requirements will have a limited impact on curbing shadow banking activities and may inadvertently push traditional banks to rely even more on shadow banking in order to sustain their financial position or to generate greater revenue. The second part of the paper examines the composition of the shadow banking system in China and then critically analyses its interconnectivity with the traditional banking system and global capital markets. It argues that whilst shadow bank lending in China contributes to the country’s economic growth, the normal functionality of capital markets could be impaired if shadow banks continue to operate on a high-risk/high-yield business model which could potentially pose a systemic risk. It also addresses the concerns arising from high-leverage shadow bank lending practice and cautions against shadow banks operating in a black hole area that enables them to escape from regulatory purview. The paper suggests that future regulatory (law) reform should guide shadow banks towards consumer protection by establishing an effective internal control system, enabling sufficient risk controls and requiring material information disclosure; towards safeguarding capital markets; and towards reducing their high levels of leverage.