Shadow loans and regulatory arbitrage: Evidence from China

This paper examines how Chinese banks used on-balance sheet shadow loans for regulatory arbitrage and whether the financial market priced in the banks’ use of shadow loans and the resulting vulnerabilities in 2014–2022. It finds that banks chose to window dress their regulatory capital ratio by using shadow loans when their capital adequacy ratio was close to the regulatory minimum. It also shows that banks with a higher shadow loan ratio or a lower breakeven non-performing loan ratio obtained from reverse stress testing faced higher wholesale funding costs. Finally, after the announcement of a rare bank failure event, more vulnerable banks witnessed lower cumulative stock and bond returns.