Chinese shadow banking, financial regulation and effectiveness of monetary policy

This paper studies the implications of the presence of shadow banking for economic activity and the effectiveness of monetary policy in China. To explore this topic, we develop a model of the Chinese economy using a DSGE framework that accommodates interacting traditional and shadow banks. China's two specific banking regulations, in the form of loan-to-deposit ratio (LDR) and loan quota, only applies to the traditional banks. Our estimates show that regulation shocks have been the major driver of China's rising shadow banking during 2009–2016. Shadow banking leads to a higher amount of credit in the economy by helping escape constraints from traditional intermediaries, however financial frictions in the shadow banking sector create a “dual financial acceleration” mechanism. We show how the presence of shadow banking negatively affects the transmission of monetary policy and the effectiveness of macroprudential policy. We also demonstrate that deleveraging policy, that has been implemented in China tightening shadow banking in the spirit of the “look-through”, may have a contractionary impact on the economy. Efficient policy frontier analysis suggests that coordinating monetary policy and leverage ratio regulation would have helped stabilize the economy while reduce the share of shadow banking.