NOTES
Shadow Banking in India
and China
Causes and Consequences
Dawa Sherpa
Shadow banking has always
played a part in India and China
to meet credit needs not catered
to by the formal banking sector.
This article argues that financial
liberalisation and deregulation
have seen shadow banking
institutions in both countries
becoming more interconnected
and more systemically important.
India and China require better
regulatory supervision based on
the functions of shadow banks to
reduce any scope of regulatory
arbitrage even if this is at the cost
of lower economic growth.
Prudential regulation like Basel III
is not of much help. What is
required is better structural
regulation of shadow financial
institutions to curb their
explosive growth.
I would like to thank Jayati Ghosh for her
guidance and valuable suggestions. I am solely
responsible for any errors and opinions
expressed. I am also grateful to Marina Rai for
her help.
Dawa Sherpa (dawa19@in.com) is a research
scholar at the Centre for Economic Studies and
Planning, Jawaharlal Nehru University,
New Delhi.
Economic & Political Weekly EPW OCTOber 26, 2013
I
n this era of global finance, shadow
financial institutions have emerged
as a major challenge to policymakers
and regulators of financial systems in
different parts of the world. Globalisa-
tion has been accompanied by rapid
financial liberalisation and deregulation,
leading to intense competition among
big financial institutions, both domestic
and foreign. Given this, the importance
of shadow banking from the point of
view of systemic stability of financial
systems and its recessionary impact on
the real economy cannot be overlooked.
Shadow banking exists alongside the
formal banking system, offering similar
kinds of services, but it is lightly or not
regulated at all. Its institutions are
therefore highly leveraged and more
prone to failure or “bank runs” (for
example, liquidity shocks) (Acharya and
Öncü 2012). After the US subprime crisis
of 2008 and the role shadow banks played
in it, they have been widely discussed in
academic and regulatory circles.1
Definitions and Features
Defining shadow banks is difficult but
very important because all other meas-
ures such as size and systemic impor-
tance depend on what we include in the
ambit of the definition. According to
the Financial Stability Board (FSB), it is
“A system of credit intermediation that
involves entities and activities outside
the regular banking system, and raises
systemic risk concerns and regulatory
arbitrage concerns” (2011). This definition
points to some features of shadow banks
such as credit intermediation outside the
tightly-regulated banking system (which
can raise systemic risk for the entire
financial system), and regulatory arbitrage
concerns (which are very prevalent
vol xlviii no 43
because most activities are meant to
overcome the strict regulatory code of
the formal banking system).
The United Nations Conference on
Trade and Development’s (UNCTAD) Trade
and Development Report, 2011 states,
“The shadow banking system depends on
wholesale funding, which is extremely
unstable and renders the system very
fragile, as evidenced by the crisis”. This
highlights the unstable source of fund-
ing and the vulnerabilities associated
with it. A more refined definition of
shadow banking is provided by Adrian
and Ashcraft (2012).
The shadow banking system is a web of spe-
cialised financial institutions that channel
funding from savers to investors through a
range of securitisation and secured funding
techniques. While shadow banks conduct
credit and maturity transformation similar
to traditional banks, shadow banks do so
without the direct and explicit public sources
of liquidity and tail risk insurance via the
Federal Reserve’s discount window and
the Federal Deposit Insurance Corporation
(FDIC) insurance.
This brings out the most important
feature – the inherent fragility of shadow
banks because of their inability to access
a lender of last resort like a central bank
and their lack of deposit insurance.
Examples of shadow banks include fina-
nce companies, asset-backed commercial
paper (ABCP) conduits, limited-purpose
finance companies, structured invest-
ment vehicles (SIVs), credit hedge funds,
money market mutual funds (MMMFs),
securities lenders, and government-
sponsored enterprises.
The prominent features of shadow
banks can be summarised as follows.
(1) They primarily borrow short-term
funds from market institutions rather
than from the public, to lend long, creating
a liquidity mismatch. They rely on finan-
cial instruments such as ABCP, MMMFs,
and repo agreements and not on bank
deposits for their funds. Hence their
assets are risky and less liquid than those
of formal banks (Acharya et al 2013).
(2) There is no government guarantee
for funds raised. In case of tail risk, they
do not have deposit insurance to cover
them (Adrian and Ashcraft 2012).
113
NOTES

(3) They have no access to central bank contagion is very high during times of 12% of bank assets as on 31 March 2012,
liquidity in times of severe distress, loss of confidence or uncertainty. and it has become the fastest growing
and are more prone to runs (Acharya segment in the Indian financial system.
et al 2013). Shadow Banking in India The year-on-year growth rates of the
(4) They are usually highly leveraged. India has a very complex and diversified NBFC sector (consisting of deposit-
They also amplify pro-cyclicality by credit system that has evolved to meet accepting NBFCs, or NBFC-Ds, and non-
increasing credit supply and asset price the various developmental needs of the deposit accepting systemically impor-
increases during booms, and worsening country. Shadow banking in India prima- tant NBFCs, or NBFC-ND-SIs) have been
the fall in asset prices during downturns rily consists of non-banking financial higher than that of the formal banking
(Sinha 2013). companies (NFBCs) and a network of sector (Table 1).
(5) They are interconnected and inter- informal financial institutions such as After liberalisation of the economy in
dependent financial entities, and this nidhis, chit funds, commodity trade fin- the 1990s, there was a huge increase in
makes regulating them very complex anciers, gold saving companies, gold the number of NBFCs and their volume of
and difficult (FSB 2012b). loan companies, pawnbrokers and money- business. From 7,063 in 1981, NFBCs
lenders. Money market funds, invest- increased sevenfold to 51,929 in 1996.
The Associated Risks ment funds, and exchange traded funds But after the Reserve Bank of India (RBI)
According to Sinha (2013), the risks Table 1: Growth in Total Assets of Banks vis-à-vis NBFCs (NBFC-Ds and NBFC-ND-SIs)
associated with shadow banking are of Item As at End
four types. 2007 2008 2009 2010 2011 2012
Banks (Rs crore) 34,59,961 43,26,486 52,41,330 60,25,141 71,83,522 82,99,400
(1) Liquidity Risk: This is the most com- Growth (Y-o-Y) 25 21.1 15 19.2 15.5
NBFCs (Rs crore) 3,66,452 4,78,997 5,60,035 6,57,185 8,66,713.7 10,38,189
mon type of risk. During the process of
Growth (Y-o-Y) 30.7 16.9 17.3 31.9 19.8
credit intermediation (liquidity and
Source: Sinha (2013).
maturity transformation), they lend to
Table 2: Regulatory Differences between Banks and NBFCs
long-term investments with short-term
Requirement Banks NBFC-Ds NBFC-ND-SIs
liabilities. There is thus the risk of liquid-
Liquidity as % of demand and time deposits Cash reserve (CRR) 6 NA NA
ity mismatch, which can cause systemic Statutory liquidity (SLR) 24 15 NA
risk as these entities are interconnected Capital as % of risk weighted assets (CRAR) 9 15 15
with formal banks. Priority sector lending as % of total credit 40 NA NA
Non-performing asset norms (days in delinquency) 90 180 180
(2) Leverage Risk: As shadow banks do Restriction of financial activity Yes No No
not have any regulatory restriction on Restrictions of foreign ownership Yes No No
borrowings, they can be highly lever- Source: Acharya and Öncü (2012).

aged. This can increase stress in the
financial system and the real economy if
recessionary tendencies develop in the
economy, making the entire financial
system more fragile.
(3) Regulatory Arbitrage: As regula-
tion in the formal banking system is very
strict in terms of source of funds, utilisa-
tion of public deposits, and exposure to
certain sensitive sectors, shadow banks
bypass these by shifting the process of
credit intermediation to lightly/non-
regulated areas of the financial system.
(ETFs) are part of mutual funds, which accepted the Shah Committee report on
are regulated by the Securities and regulation of NBFCs in 1997, NBFC-Ds
Exchange Board of India (SEBI). Hedge came under strict regulation, while the
funds are regulated by the SEBI and are rest were lightly regulated. The number
not an important player. Collateralised of NBFC-Ds (including residuary NFBCs)
debt obligations (CDOs) and credit declined by 700% from 1,429 in March
default swaps (CDS) are not allowed in 1998 to 273 in March 2012. The deposits
India. The Indian banking system does held by these institutions declined by
not follow “originate and Figure 1: Number of All NBFCs
distribute” models, which 16,000
was used by banks in the
14,000
US to transfer risk off-
balance sheet using SIVs 12,000
(Sinha 2013). 10,000

Sinha (2013) observes 8,000

(4) Contagion Risks: Shadow banking
consists of networks of highly con-
nected and interdependent entities. Any
shock to one entity or part of the net-
work can cause the entire system to go
down. The formal banking system has
interlinkages from both assets and lia-
bilities sides, and the risk of spread of
114
that NBFCs are the core
6,000
shadow banks because
they perform credit inter- 4,000
mediation just like formal 2,000
banks, but outside the pur- 0
view of banking regula- 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
tions. The assets of the The numbers used in Figures 1-7, 10, 11, and 12 are replicated from the sources
and are meant to give a broad view of trends.
NBFC sector accounted for Source: Acharya et al (2013).
OCTOber 26, 2013 vol xlviii no 43 EPW Economic & Political Weekly
 NOTES

50% in the same period, from Rs 23,800 banking in India. Table 3 shows the prof- mostly relied on short-term funding
crore to Rs 10,100 crore. The increasing itability and financial soundness of the sources (which constituted 56.8% of the
size, enhanced risk-taking capacity, NBFC-ND-SIs from 2009 to 2012. Though total borrowing of these institutions in
wider financial market interlinkages, and their number increased, Figure 2: Number of NBFC-Ds and NBFC-ND-SIs
complexity of activities of some of the returns on assets and 900
non-deposit accepting NBFCs prompted equity declined from 800
the RBI to create a new category called 2009 to 2011, indicating 700
NBFC-ND-SIs in 2006. Those that came decreased profitability and
600
under this were non-deposit accepting worsening resource mobi-
NBFCs with an asset size of Rs 100 crore, lisation. The capital ade- 500
NBFC-D
and they were subjected to capital quacy ratio and the gross 400
NBFC-ND-SI
adequacy, credit concentration, liqui- non-performing asset 300
dity, and information disclosure norms (GNPA) ratio declined,
200
(Sinha 2013). though there was a mar-
Figure 1 (p 114) shows the rise and fall ginal increase in the lev- 100
in the number of NBFCs from 1999 to 2011. erage ratio from 2.7 in 0
Their number increased dramatically in 2009 to 2.9 in 2012. 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
2001, but gradually declined between According to Acharya Source: Acharya et al (2013).
2003 and 2011. The emergence of NBFC- and Öncü (2012), loans to NBFCs (NBFCs-Ds September 2008) such as debentures
ND-SIs in 2006 can be seen in the Figure 2, and NBFC-ND-SIs) from banks and finan- and commercial papers to finance a mix
and their number has been continuously cial institutions form a significant pro- of long-term assets (hire purchase and
increasing, while that of deposit-accepting portion of their liabilities, inducing a lease assets, long-term investments,
NBFC-Ds has been decreasing. potential two-way linkage between the investments in the real sector by some,
Table 2 (p 114) shows the regulatory banking sector and NBFCs. Bank and and loan and advances). Their liquidity
differences between banks and NBFCs. financial institution loans increased Figure 3: Growth of Assets of NBFC Sector
Cash reserve ratio (CRR) and statutory from 18.85% of total liabilities in 2006 to (Excluding RNBCs, in Trillions of rupees)
liquidity ratio (SLR) are not applicable in 18.79% in 2010, and further to 21.70% in 8

the case of NBFC-ND-SIs, but NBFC-Ds have 2011. Another notable feature is that the
to maintain an SLR of 15%, which is much major part of assets owned by NBFCs 6

lower than the 24% for banks. Both consists of loans and advances. In 2006, NBFC-ND-SI
types of NBFCs have no restrictions on it constituted 51.25% of the total assets, 4
NBFC-D
financial activity and foreign ownership. which increased to 59.87% in 2010 and
Figure 3 shows the growth of assets of further to 63.27% in 2011. 2
the NBFC sector, excluding residuary
non-banking companies (RNBCs), from Causes and Consequences 0
2006 2007 2008 2009 2010 2011
2006 to 2011 in trillions of rupees (Rs 1 Source: Acharya et al (2013).
trillion is Rs 1,00,000 crore). From their (1) Financial Deregulation and Increas- Figure 4: Assets of NBFC Sector
emergence in 2006, the assets of NBFC- ing Interconnectedness: After the advent (excluding RNBCs) as Percentage of Bank Assets
12
ND-SIs have been higher than those of of neo-liberal policies in the guise of new NBFC-ND-SI
10
NBFC-Ds and they have been increasing. economic reforms in the early 1990s, the NBFC-D

Figure 4 shows that the assets of NBFC- government gradually liberalised finan- 8

ND-SIs account for 9% to 10% of the cial institutions. This process of deregula- 6
assets of banks and are gradually rising. tion saw shadow financial institutions like 4
Assets of NBFC-Ds account for only 1.5% NBFCs becoming more interconnected
2
to 1.8 % of the assets of banks. with other areas of the financial system
0
Table 3: Profitability and Financial Soundness of and more complex in terms of their activi- 2006 2007 2008 2009 2010 2011
NBFCs-ND-SI Sector ties and risk-taking positions. They thus Source: Acharya et al (2013).
NBFCs-ND-SI Sector 2009 2010 2011 2012
became more vulnerable to shock gener- risk turned real since they lacked liquid-
Return on assets (%) 2.2 2.1 2.1 1.8
ated in other financial markets, creating ity support from the RBI. The crisis in the
Return on equity (%) 8.3 7.5 8.4 7
Capital adequacy ratio 39 42.1 32.8 27.5
increased systemic risk. US and European markets led a “flight to
Leverage ratio 2.7 2.6 2.9 2.9 The vulnerabilities of the NBFC sector security issue”, which led to liquidity
GNPA ratio 2.9 2.8 1.8 2.2 were exposed during the 2008 crisis as and heavy redemption pressure on
Source: RBI (2013). there were strong funding interlinkages mutual funds in India as institutional
It is evident NBFC-ND-SIs constitute a among NBFCs, mutual funds, and com- investors started pulling out their invest-
major part of the NBFC sector, which in mercial banks. NBFC-ND-SIs were caught ments in liquid and money market
turn is a significant part of shadow in liquidity mismatch problems as they funds. This in turn squeezed the funding
Economic & Political Weekly EPW OCTOber 26, 2013 vol xlviii no 43 115
NOTES
source of NBFCs as mutual funds were
the major subscribers of commercial
papers and debentures issued by them.
Bank funding was also squeezed as they
became very risk averse (Sinha 2013).
(2) Financial Exclusion: Small and
medium enterprises (SMEs) and small
personal businesses find it difficult
and costly to access formal bank credit,
and the different types of NBFCs fill
this gap. The poor are also usually
denied formal bank credit due to lack of
collateral, low income, and the high
probability of default. But microfinance
NBFCs provided easy access to funds to
the poor and self-employed at very high
rates of interest. Having no other option,
the poor were willing to pay high rates
to get access to credit for various pur-
poses. Microfinance NBFCs were even
hailed as bankers to the poor, which
were ushering in a new model of financ-
ing development.
Most of these NBFCs were for-profit
entities, charging high interest rates.
As more new players entered the field
and competition grew, lending condi-
tions became more liberal. This meant
more and more undeserving borrowers
got access to credit. As the interest rate
was high and loans were used for
unproductive consumption, the repay-
ment capacity of borrowers declined,
leading to many cases of default. In
brief, money was lent to the poor with-
out checking their actual target expend-
iture, and it was often used to fulfil
social obligations, which yielded no
return. Many microfinance institutions
operating in the same area and trying
to reach out to the same set of poor
people resulted in borrowers taking
loans from multiple outfits, overburden-
ing households. Some microfinance com-
panies used coercive methods to make
poor borrowers pay back, and the number
of suicides among the indebted rose
dramatically. The problem became acute
in Andhra Pradesh in 2006 (Nair 2011)
and the government was forced to inter-
vene and regulate these for-profit micro-
finance NBFCs. When the microfinance
bubble burst, many NBFCs got into trouble,
and the finances of the poor became
more precarious.
116
The microfinance fiasco clearly showed
that “financial inclusion” is bound to
get into deep trouble if not supported by
economic inclusion. Rather than tinkering
with micro measures, we need better
macroeconomic policies (more govern-
ment expenditure/subsidies in employ-
ment-intense sectors, higher wealth and
income tax, some form of capital control,
and so on), which generate more egali-
tarian distributional outcomes to sup-
port the process of financial inclusion
and reduce the demand for services pro-
vided by shadow financial institutions.
New Shadow Banking Activities
Gold loan NBFCs are now the most active
shadow financial entities in India. Their
primary business is giving loans against
gold jewellery pledged as collateral by
individuals. Rising indebtedness in rural
areas, quick and easy access to loans
with very little paper work, a reduction
in retails, and the availability of personal
loans are cited as the major causes for
the explosive growth of gold loan NBFCs.
At the same time, their rising asset size,
greater dependence on bank funding,
high concentration, and high leverage
are raising systemic concerns among
regulators (RBI 2013).
The interlinkage of gold loan NBFCs
with the formal banking system is
shown by that borrowing from banks is
their major liability – 47.3% in 2012
(Table 4). On the asset side, more than
85% consists of loans and advances given
against gold. The leverage ratio of gold
loan NBFCs is very high compared to
NBFC-ND-SIs. It was 6.5 in 2009 and 5.6 in
Table 4: Profitability and Financial Soundness of Gold Loan NBFCs
Gold Loan NBFCs
Assets of gold loan NBFCs (Rs crore)
Share of gold loan NBFCs in total assets
of NBFC-ND-SIs and loan companies
Bank borrowing as percentage of total liabilities
Loan and finance as percentage of assets
Leverage ratio of gold loan NBFCs
Return on assets
Source: RBI (2013).
2012 compared to 2.7 and 2.9 for NBFC-
ND-SIs in the same years. Profitability is
good, with return on assets at 4.6% in
2012. The value of the collateral is quite
stable as gold prices are usually rising.
But a recent free fall in the price of gold
in the international market affected the
OCTOber 26, 2013
asset quality of the gold loan portfolios
of NBFCs and banks.
Shadow Banking in China
In contrast to the shadow banks in the
developed world, shadow banking in
most developing countries consists of a
broad spectrum of financial institutions
in the informal financial system. Follow-
ing the financial deregulation of 1979,
such institutions have existed for dec-
ades in China without creating any sys-
temic risk to the financial system. There
are some restrictions on them and inter-
linkages are very low, decreasing the
contagion risk (Hsu et al 2013).
Most of the shadow financial institu-
tions in China incorporate all informal
financial systems. They are not as devel-
oped or large as their developed country
counterparts as institutions such as hedge
funds, MMMFs, ABCP, CDS and CDOs are
small in size (of assets) and tightly regu-
lated, or, in some cases, not allowed at
all. Chinese shadow financial institu-
tions mainly consist of trust companies,
small loan companies, bonding compa-
nies, financial companies, and financial
leasing companies. Hsu et al (2013) have
used People’s Bank of China (PBOC) data
for 2011 to show that the system-wide
financial aggregate is RMB 12.83 trillion.
Formal bank loans comprise 58.3% of
this, which means general shadow activ-
ities constitute 41.7%. A recent estimate
suggests that the total size of shadow
banking in China has reached RMB 22.8
trillion, which is nearly 44% of gross
domestic product (GDP) (Credit Suisse
2013a). The informal financial sector,
2008 2009 2010 2011 2012
3,577 5,694 11,538 27,206 45,479
3.12 3.85 7.13 13.05 18.9
26.9 27.6 39.8 47.7 47.3
83.5 68.5 79.8 83.3 86.5
6 6.5 6.4 5.7 5.6
3.1 2.9 4 3.8 4.6
which excludes money market funding
of capital market lending, is included
despite variations in definitions of sha-
dow banking. It also includes non-bank
financing that has extensive ties to sec-
tors that fund capital markets through
money markets.
vol xlviii no 43 EPW Economic & Political Weekly
 NOTES

China’s shadow financial system com-
prises three levels (Li and Hsu 2012).
Commercial banking and investment
bank ing, including bank-trust coopera-
tion in financial products; investment
banks; financing leasing companies;
and insurance brokerage firms and
their products constitute the first level.
Quasi financial institutions such as
micro loan companies, financing guar-
antee companies, and pawn shops form
the second level. The third includes
informal financial institutions and busi-
ness activities. In operational terms,
China’s shadow banking differs from the
US shadow banking system as commercial
banks in China inherently have elements
its recovery in 2010 after the massive
stimulus programme. Figure 6 shows
that there was a substantial rise in the
level of credit in the economy after
2008. Outstanding credit in the econ-
omy increased from around RMB 32 tril-
lion in 2008 to RMB 55 trillion in 2011.
The credit to GDP ratio recovered signifi-
cantly after the second quarter of 2008
and has remained more or less stable.
The overall credit to GDP ratio has also
shown a rising trend.
Figure
% 5: Contribution of Consumption, Investments, and Exports to GDP Growth (in %)
100
Contribution of ultimate
consumption to GDP
80
Contribution of capital
formation to GDP
60
growth, leading to euphoria among
lenders and borrowers, and making
lenders less cautious about the quality of
loans (Chandrasekhar 2013).
(2) Financial Exclusion: As the grow-
ing need of SMEs for credit is not met by
the formal banking system (commercial
banks), there has been a growth of
shadow entities in the form of micro
loan companies, investment companies,
pawn shops, rural credit cooperatives,
%
16
Y-o-y growth of
GDP (right scale)
14
12

of shadow banking to them “by cooperat- 40 10

ing with trust and investment companies
20 8
or transferring deposits into financial
management products and lending the 0 6
funds to short run projects investors” -20 4
(ibid). For other shadow banking activi- Contribution of net
export to GDP
-40 2
ties such as property securitisation, MMMFs
and discounted instruments, commercial -60 0
banks only act as intermediaries rather 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Financial Stability Analysis Group (2012)
than institutions backing these funds
with reserves. Figure 6: Growth of Credit in Chinese Banking System
RMB trillion (%)
Shadow banking in China has released
70 140
a huge amount of funds to the market. Credit/GDP (left scale) Trend of Credit/GDP (right scale)
60 120
The following are the reasons for the
growth of shadow banking in the country. 50 100

40 80
(1) Failure of Export-led Growth: After 30 60
the global financial crisis of 2008, China’s Outstanding Credit (left scale)
20 40
net export demand plummeted into the
negative zone (-40% of GDP in 2009) 10 20

(Figure 5). To contain the recessionary 0 0

impact, China introduced a massive
stimulus plan of RMB 4 trillion (Deloitte
China 2012). Though it helped maintain
healthy macroeconomic conditions (stable
output and employment), it raised the
size of debt in the economy. According to
a World Bank estimate, credit to the pri-
vate sector increased from 104% of GDP
in 2008 to 130% in 2010, but decreased
slightly in 2011 (Chandrasekhar 2013).
Local government deficit to GDP ratio
reached 8.5% in 2011 and money and
quasi money (M2) to GDP ratio reached
187% in 2013 (Credit Suisse 2013). A
large part of this lending went through
the channel of shadow banking.
Figure 5 shows the decline of GDP
growth after 2007 due to the crisis and
Economic & Political Weekly EPW OCTOber 26, 2013
2000 2001 2002 2003
Source: Financial Stability Analysis Group (2012).
As export demand did not recover
much after the crisis, the Chinese gov-
ernment increasingly relied on debt-
financed domestic investment and con-
sumption to sustain the current level of
growth of the economy. A prerequisite
for success of this strategy is continuous
expansion of the number of borrowers,
which is accompanied by liberal lending
conditions and supported by a strong
sense of confidence among lenders
and creditors. In China’s case, the
earlier years of impressive growth of
the economy provided this confidence,
which created the impetus to lend more.
The higher lending generated more
vol xlviii no 43
2004 2005 2006 2007 2008 2009 2010 2011
and mutual assistance organisations,
which provide credit for short periods of
time at rates determined by the organi-
sation’s or individual’s bargaining power,
and demand conditions in the informal
credit market. The rates charged by bond-
ing companies, pawn shops, and small
loan companies are higher than normal
bank lending rates, generating huge
profits for these institutions, which are
again pumped back into the shadow
banking system. Some of the transac-
tions are not very transparent or fre-
quent, and are primarily based on social
relationships. When both parties know
each other very well, informal finance
117
NOTES
Figure 7: Trust Sector Assets under Management insurance sector (Figure policies in 2010 and 2011. This led to a
8,000
7). According to Credit reduction in credit available to the entire
Suisse (2013a), brokers’ economy, with greater impact on SMEs,
6,000
asset management busi- forcing them to rely more on informal
Rmb bn ness is growing at a pace sources. This was followed by a huge
4,000
of RMB 10 billion per increase in the size of shadow financial
day. By offering lucra- institutions.
2,000
tive financial products
and allowing high-risk Consequences of Shadow Banks
0
2007 2008 2009 2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 financial activities like in China
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007,2008 and 2009 figures are numbers reported by local press, figures for 2010
asset securitisation, it has
onward are released by China Trustee Association. the potential to make (1) Creation of Asset Bubble: The
Source: Credit Suisse (2013a).
the system more fragile spending from China’s economic stimu-
increases the speed with which loans by promoting more and more shadow lus programme made its way into real
are given. So search costs for lender and banking activities. estate, contributing to a bubble. Com-
borrower are minimised and SMEs are mercial banks are strictly regulated in
able to find the least costly loans. Rising (4) Other Macroeconomic Factors: The terms of exposure to real estate and
income inequality has also created a fall in returns of two major stock credit quotas. So the huge growth in real
wealthy class looking for avenues to markets – Shanghai and Shenzhen – in estate was primarily financed through
invest their surplus. Growing financial China after 2008 has been very high financial products like WMPs, and quasi-
instruments such as wealth manage- compared to stock market returns in real estate investment trust (Q-REIT)
ment products (WMPs) are meeting this other countries. Both markets had been products issued by shadow financial
demand (Li and Hsu 2012). showing a declining trend, and the value of institutions such as financing guarantee
the Shanghai Stock Exchange Composite companies, Q-REIT, and pawn shops. In
(3) Liberalisation and Deregulation: Index fell by 21.68% and the Shenzhen 2003, China distributed 84 real estate
China has gradually liberalised its finan- Stock Exchange Composite Index fell by trust products with a total value of RMB
cial sector, which was highly regulated. 28.41% between January and December 7,773 million. In 2011, the number
The process increased competition among 2011 (FSB 2012a). increased to 1,062 products with a total
domestic and foreign players and even Growing inflationary pres- Figure 8: Inflation (CPI), Deposit Rate, and Real Deposit Rate
among domestic commercial banks and sure in the economy after 8 Inflation CPI
shadow financial institutions. The cen- the global financial crisis 6
Deposit rate
tral bank uses interest rate regulation contributed to increasing 4
and direct credit allocation to regulate the size of shadow banking 2
commercial banks. The stimulus pro- in two ways. First, it made 0
gramme of 2008-09 saw rapid expan- the real return on bank -2
sion in credit, which caused inflationary deposits very low compared Real deposit rate
-4
pressure in economy. The real deposit to the high level of return
rate became negative, and deregulation promised by shadow finan- -6 2003 2004 2005 2006 2007 2008 2009 2010 2011
of the shadow banking sector began cial institutions with instru- Source: Based on World Bank data.
simultaneously. New complex financial ments like WMPs. Figure 8 Figure 9: Shadow Banking Activities in China (as of 2010, US$, billion)
products like WMPs were allowed to shows that the real deposit
Securitisation 2.75
meet credit needs. This ensured that rate was negative from the
restrictions like credit quotas on com- last quarter of 2003 to the Trusts’ Credit- 250.76
related WMP
mercial banks were not necessary and beginning of 2005. But the
12.79
credit could be increased as a stimulus size of shadow banking Pawn

to growth. Commercial banks overcame remained small and insig- Small lending 24.52
companies
regulation by transferring their risky nificant. Hence it was infla-
activities off balance sheet. The total tion accompanied by rapid VC 5.67

size of banks outstanding WMPs increased deregulation after 2008

PE 19.61
from RMB 500 billion in 2007 to RMB 7.6 that fuelled the massive
trillion in 2012 (Credit Suisse 2013a). In a growth of shadow financial 0 50 100 150 200 250 300
Source: Min (2011).
few years, assets managed by shadow institutions (Long 2013).
institutions rose significantly. Second, due to the rise in inflation as value of RMB 2,74,185 million, and an
The trust sector has now become captured by the rising consumer price average yearly return as high as 10.09%.
the second largest financial sub-sector index (CPI) in Figure 8, the central bank Q-REIT have been experimented with in
with assets greater than those of the had to intervene by tightening monetary Beijing, Tianjin and Shanghai. In some
118 OCTOber 26, 2013 vol xlviii no 43 EPW Economic & Political Weekly
 NOTES

other places like Henan province, real the country is now facing. Empirical The central bank’s effort to control infla-
estate businesses even register through findings suggest that shadow banking is tion by reducing the growth of credit
financing guarantee companies to increasing systemic risks, and over- through reducing money supply can be
obtain financing (Li and Hsu 2012). growth of the banking system will minimised by the availability of large
Figure 10: Growth of Real Estate Investment, Floor Area of Newly Built Housing, and Sold Area amounts of liquidity from shadow finan-
% Estate (%)
of Real cial entities. So its effort to prevent
40
Growth of real estate overheating of the economy may not be
fully effective.
30 Growth of floor area of newly built housing
Comparison: India and China
20 Figure 11 shows the share of total assets
Growth of the sold area of
commercial real estate by jurisdiction in India and China. The
10 share of banks and the central bank in
China was higher than in India from
0 2002 to 2011. Banks’ share of total assets
2011-02 2011-03 2011-04 2011-05 2011-06 2011-07 2011-08 2011-09 2011-10 2011-11 2011-12 in China varied from 65% to 70% com-
Source: Financial Stability Analysis Group (2012).
pared to 56% to 62% in India. The share
Most of the funds collected through increase financial fragility (Zou et al of total assets of other financial institu-
WMPs were invested in real estate or 2012). As shadow banks’ size and inter- tions (OFIs) was higher in India than in
financial markets to get the higher return connection with financial institutions China, indicating that the proportion of
promised to investors. This increased grow, any trouble with these institutions shadow banks is much higher and the
investment in real estate by shadow fina- have the potential of freezing the entire economy is more prone to runs. It can
ncial institutions created and inflated the credit pipeline, which can bring down also be seen that share of Indian shadow
asset bubble, which is now in the process growth of output, causing massive job banks was relatively larger than that of
of being corrected. As Figure 10 shows, losses in a very short period of time. The Chinese ones after 2007-08.
Figure 11: Share of Total Assets by Jurisdiction (%) %
% India China
70 80
Banks Banks
70
60
60
50
50
40
Other Financial
Institutions (OFIs) 40
30 Insurance companies Central Bank
Insurance companies Central Bank and pension funds
and pension funds 30
20
20
Other Financial Public Financial Institutions (PFIs)
10 Institutions (OFIs)
Public Financial Institutions (PFIs) 10
0
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: FSB (2012a). 2003 2004 2005 2006 2007 2008 2009 2010 2011

growth of sold area of commercial real
estate reached 15% in February 2011 but
fell to 5% in December 2011, indicating the
real estate bubble was getting corrected.
external source of stimulus has not Figure 12: Average Annual Growth of OFI Sector
in Pre-
% and Post-crisis Periods (%)
recovered and is not likely to recover
120
very soon. Since there is an implicit or
explicit guarantee by banks to shadow 100

Similarly, declining growth of investment banking activities, any shock to shadow

80
in real estate and growth of area of newly banks can easily get transmitted to
built housing indicates that demand is commercial banks, creating systemic 60
2002-07
going down. The end of the property risk concerns.
40
bubble is seen as one of the primary 2007-11
causes for China’s declining economic (3) Monetary Policies Ineffective: As 20
growth in 2012. the size of shadow banking institutions
0
increase, the effectiveness of monetary India China
(2) Increasing Fragility of Financial policies in controlling inflation goes Source: FSB (2012a).

System: The president of the China
Banking Regulatory Commission (CBRC)
has pointed to shadow banking risks as
one of the three major risks banking in
Economic & Political Weekly EPW
down. The effect of a reduction in offi-
cial money supply (M1) can be nullified
or diluted by the increase of liquidity by
shadow financial entities (Min 2011).
OCTOber 26, 2013 vol xlviii no 43
Figure 12 highlights that India’s sha-
dow financial institutions have grown
much faster than China’s in the post-
crisis period. It indicates that regulators
119
NOTES
in India should be more concerned
by this rapid growth. In China’s case,
even at a low growth rate of 4% per
annum, the sheer size of the country’s
shadow institutions and the rising
number of recent failures, as well as the
asset bubble crash, is a major concern
for policymakers.
Regulatory Response to
Curb Rapid Expansion
In China
All regulatory measures implemented
in China to curb shadow banking have
sought to minimise linkages between
commercial banks and capital markets,
prohibit banks from guaranteeing cor-
porate bond issues, and limit com-
mercial banks’ reliance on the capital
market for liabilities-side funding. Both
on-balance sheet items and off-balance
sheet items have been given equal
treatment in terms of risk weightage
(Min 2011).
Deloitte’s 2012 report on the Chinese
banking industry highlighted certain
regulatory measures taken to contain
shadow activities. Commercial banks
were forced to incorporate off-balance
sheet exposures to the balance sheet at a
minimum rate of 25% per quarter since
2011. Trust companies were obliged to
calculate risk capital at a ratio of 10.5%
for trust loans issued by banks and trust
company cooperation. Certain classes
of loans, like those by mandate and
notes financing, which are usually high-
yielding assets, were banned in July
2011. In October 2011, all the banks were
asked by the CBRC to clear their “assets
pool” within one month and adopt
stand-alone accounting on financial
management plans.
In March 2012, in Wenzhou, an attempt
was made to assimilate shadow banks
into the formal system by converting
underground shadow institutions into
local banks to serve the needs of SMEs
(Ghosh et al 2012). To overcome the rela-
tive disadvantage of commercial banks
vis-à-vis shadow banks’ product returns,
the PBOC in June 2012 allowed them to
set the interest rates charged on their
loans at or above 80% of the govern-
ment’s benchmark rate and to set deposit
120
rates at or lower than 1.1 times the gov-
ernment benchmark rate (Huang 2013).
Recently, the CBRC imposed a new regu-
lation, which limits the investment in
non-standard assets to 35% of total out-
standing WMPs or to not more than 4%
of a bank’s total assets at the end of the
previous year (Credit Suisse 2013b).
In India
After the crisis of 2008 exposed the vul-
nerabilities of shadow banks and pointed
to regulatory inadequacies, a working
group on NBFCs chaired by Usha Thorat
was formed, and it submitted its report
in August 2011. The committee suggested
the following measures:
• To insulate the spillover of risk from
financial activities, raise the threshold
for principle business from 50% to 75%.
• Each NFBC is considered systemically
important if its combined asset size is
equal to or greater than Rs 100 crore.
• Depending on the level of risk expo-
sures of NBFCs to sensitive sectors such
as the capital market, commodities, and
real estate, raise the minimum Tier-1
capital requirement. Identical risk wei-
ght is suggested for NBFCs that are part
of banking groups.
• Converge regulatory requirements for
NBFCs and banks in terms of asset classi-
fication and provision norms. Even in
terms of prudential regulation, a certain
uniformity of treatment is suggested
depending on the level of similarity of
asset financed. Both should be 90 days,
rather than 180 days for NBFCs.
• To protect depositor interest, NBFC-Ds
should get ratings. A one-year period is
to be given to NBFC-Ds to get ratings and
those failing to do so will not be allowed
to take deposits from the public.
As a liquidity coverage requirement,
all registered NBFCs are to be required
to maintain high quality liquid assets in cash,
bank deposits available within 30 days,
money market instruments maturing within
30 days, actively traded debt securities (val-
ued at 90% of the quoted price and carrying
a rating not lower than AA or equivalent),
equal to the gap between total cash inflows
and outflows over the 1 to 30 day time bucket
(Sinha 2013).
It is also stipulated that all registered
NBFCs be required to get RBI approval if
there is a change in control or a major
OCTOber 26, 2013
increase in shareholding, and when
large NBFCs (with asset size of more
than Rs 1,000 crore) appoint chief exec-
utive officers (CEOs). Basically, more
emphasis is to be given to Basel III pru-
dential norms to contain shadow banks
in India.
Basel III and Shadow Banking
The Basel III prudential regulation norms
will not solve the problem of shadow
banking due to following reasons.
Rather, it may further accentuate it.
(1) Fundamentally Micro Prudential
in Nature: Most of the Basel accord is
micro prudential in nature and not very
effective in dealing with a problem that
is primarily a macro phenomenon – sys-
temic risk. Though there is a shift to
macro prudential regulation in Basel III,
it still addresses the risk arising at the
level of individual banks rather than sys-
temic risk of the banking sector as whole
(Acharya 2012).
(2) Regulatory Capture: There is a
strong element of regulatory capture in
the design and implementation of all
Basel accords. Speculation that a strong
lobby of large financial conglomerates in
developed nations Group of Ten (G-10)
was influential in designing these regu-
latory frameworks cannot be too far
from the truth (Griffith-Jones and
Persaud 2008). Virtually all large and
complex financial institutions (LCFIs)
are able to bypass the strong regulatory
requirements using the leeway of evalu-
ation of risk through the internal
ratings-based approach (IRB) and mini-
mising value at risk (VAR). As idle capital
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vol xlviii no 43 EPW Economic & Political Weekly

is costly and LCFIs can earn good profits
from additional capital freed from
regulatory requirements, they had a
vested interest in declaring as low a
risk as possible using all sorts of compli-
cated models for risk evaluation. It
implies that the regulatory capitals of
these LCFIs are far below the levels fi xed
by the Basel accords (Acharya 2012;
Perera 2012).
(3) Reduction in Bank Lending and
Increasing the Size of Shadow Banks:
Both the quantity and quality of capital
has been raised in Basel III (higher
requirement of tier I capital and other
buffer capital and leverage restrictions).
If it is adopted in toto in developing
countries, most banks will be forced to
reduce credit because raising additional
tier I capital and maintaining additional
capital in the form of buffer and counter-
cyclical capital will raise the cost of lend-
ing. In addition, international banks will
lend less to banks in developing coun-
tries for the same reason. This will
increase lending rates and lower lending
volumes in emerging nations (Perera
2012). Most importantly, the stringent
requirements of Basel III have the poten-
tial to reduce trade finance, which is the
most important source of working capi-
tal (Vincenzo 2010). This will force them
to rely more on shadow banking for their
credit needs.
(4) Implicit Faith in Market-mediated
Regulation: Basel II and III are funda-
mentally market-mediated regulations
where the market is supposed to impose
proper discipline among banks via the
mechanism of enhanced information
disclosure to market participants such as
customers, investors, rating agencies,
and analysts. The market will reward
and punish managers of banks accord-
ing to their risk management practices.
The implicit assumption is that given
better disclosure and accounting norms,
the capital adequacy requirement will
be sufficient to prevent a crisis in the
financial system (Chandrasekhar 2010).
This idea of market-mediated regulation
is somewhat antithetical to the notion
of prudential regulation. It misses the
fundamental nature of the financial
Economic & Political Weekly EPW OCTOber 26, 2013
market (including banks), which is en-
meshed in moral hazard, information
asymmetry, herding, and tail risk. Even
relatively better-informed market partic-
ipants cannot avoid herding behaviour
(Griffith-Jones and Persaud 2008). It also
forgets the political economy of globalised
finance. The starkness of regulatory cap-
ture was evident during the 2008 crisis,
which was an outcome of spontaneous
market reactions.
Conclusions
Some form of shadow financial institu-
tion has always existed in both India and
China to cater for certain types of credit
needs that the formal banking system
cannot provide. In both countries, they
are better regulated than their counter-
parts in developed and developing coun-
tries, including the US and European
Union (EU). They existed for a long time
without creating any systemic concern for
the financial system as a whole. But with
the process of financial deregulation,
these institutions in both countries have
become more interconnected and more
systemically important. Macroeconomic
imbalance caused by the crisis in the US
and EU forced China to initiate a massive
stimulus programme. Its case highlights
the danger of relying excessively on
export-driven growth. The fall in export
demand during the crisis, a failure to
provide affordable credit to SMEs, a low
rate of real return on bank deposits, and
handsome returns promised by shadow
financial institutions fuelled the rapid
growth of shadow banking in China. It
was forced to allow these shadow finan-
cial institutions to flourish to maintain
domestic credit-driven growth as part of
the stimulus programme.
In India, it was the process of liberali-
sation that allowed the interconnection
of shadow banking institutions and the
formal banking system. Regulatory for-
bearance in the case of many NBFCs like
microfinance institutions failed to pre-
vent a crisis in Andhra Pradesh. Massive
economic exclusion, which is reflected
in financial exclusion, is also fuelling
shadow banking in India. Both countries
require better regulatory supervision
based on the functions of shadow banks to
reduce any scope of regulatory arbitrage
vol xlviii no 43
NOTES
even if it is at the cost of lower GDP
growth (UNCTAD 2011). Prudential regu-
lation like Basel III will not be of much
help. Imposing higher capital require-
ments in terms of a higher capital ade-
quacy ratio and additional countercycli-
cal buffer capital will worsen the credit
access of SMEs by raising the cost of capi-
tal for formal banks. Better structural
regulation of shadow financial institu-
tions with differential treatment for
various sectors is needed to curb the
explosive growth of shadow financial
institutions.
A supportive macroeconomic environ-
ment (e g, keeping the real interest rate
positive and keeping inflation low) has
to be created if this regulatory structure
is to be sustained over a long period.
One measure could be to impose an
interest rate ceiling on instruments that
shadow institutions offer. We also need
a more egalitarian distribution of
national income to prevent financial
exclusion, which generates demand for
shadow banking instruments. As Ghosh
et al (2012) say,
The FSB has emphasised the need to keep the
system ‘under permanent surveillance, since
new risks and new interconnections are cre-
ated in the global economy’, as financial
institutions adjust to a changing regulatory
and economic environment.
Note
1 See FSB (2011, 2012a, 2012b); Adrian and
Ashcraft (2012); Acharya (2012); Min (2011);
Sinha (2013); Ghosh et al (2012).
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