Optimal Shadow Banking

A puzzle of China’s shadow banking system is its stark growth since the 2008 Subprime Crisis, which is in sharp contrast to most of countries. We present a model to explain why the shadow banking activities have been allowed to expand with the full awareness of regulators in China. In the presence of local government intervention, which tends to distort the banks’ portfolio choices towards inefficient low-quality projects, the policy combination of formal banking sector credit tightening and shadow banking sector loosening forces banks to improve credit quality. This is because shadow banking assets are less diversified than commercial bank assets, thereby subject to higher bank run risk, which forces banks to improve the quality of shadow banking assets. Negative shocks to project quality may trigger information production in the shadow banking sector and prevent banks from providing funding to efficient projects, which creates additional welfare losses. This result provides a rationale for China's new regulations on shadow banking sector since 2018 in the background of increasing risks.