Seeking to slow credit, China instead created a boom

A story of unintended consequences in three parts

Brian Wallheimer | Nov 08, 2016

Sections Finance

When China implemented a new banking rule in 2008, officials believed that would slow the credit market. Instead, credit soared.

Chicago Booth’s Kinda Hachem and Zheng Michael Song of the Chinese University of Hong Kong have an explanation for what happened. They argue that the rules change led small Chinese banks to engage in “shadow” banking, which affected lending and the interbank loan markets.

1. Regulation hurts small banks

The Chinese banking system differs somewhat from that of Western countries. Chinese banks have traditionally faced binding ceilings on the returns they can offer depositors. This benefits banks with deeply entrenched retail networks, particularly the four banks established by the government after the Cultural Revolution. Small banks, unable to use higher interest rates to entice deposits away from larger competitors, resort to lending more aggressively. 

In 2008, China began enforcing a rule that mandates banks keep at least 25 percent of deposits on hand as reserves. But that hurt small banks, which often loan as much as 90 percent of deposits. And according to Hachem and Song, those small banks turned to shadow banking.

2. Small banks create a workaround

The banks offered off-book “wealth management products” whose returns topped the ceiling on traditional deposits. They didn’t explicitly guarantee returns, but they told customers to expect a certain percentage—and they achieved these returns by loaning customers’ money to trusts. The products attracted more customer business, which created more liquidity that the banks used to arrange more loans.

“The bank-trust cooperation just described constitutes shadow banking: it achieves the same type of credit intermediation as a regular bank without appearing on a regulated balance sheet. It also achieves the same type of maturity transformation as a regular bank, with long-term assets financed by short-term liabilities,” the researchers write.

3. Large banks strike back

The four largest banks responded to the competitive threat by holding funds back from the interbank market, where small banks often turn for overnight loans to meet liquidity needs. The large banks subsequently hiked interest rates on the interbank market, creating instability to force small banks to keep more cash on hand and scale back their fast-growing shadow banking. But because big banks then made less money on the interbank market, they issued more loans of their own to compensate for the lost income.

The end result: a credit boom, and a tighter, more volatile interbank market because of, not in spite of, higher liquidity standards.