Implicit Guarantees and the Rise of Shadow Banking: The Case of Trust Products

A central feature of China’s shadow banking sector is the prevalence of implicit guarantees that investors come to expect for returns on risky investments. We develop a theoretical model and argue that project screening by financial intermediaries such as trust companies, accompanied by their implicit guarantees on project payoffs, can be the second best arrangement in funding risky projects. Using a comprehensive set of investment products sponsored by all the licensed trust companies, we document evidence consistent with the model’s predictions about the ex ante pricing of the products and ex post recourse in case of defaults on the products. In particular, initial yields of the products not only reflect borrower risks, but also reflect the strength of implicit guarantees, including the characteristics of the issuing company and its controlling shareholder, and whether the product is sold through a large bank. In addition, the spread-to-risk sensitivity is flattened by strong guarantees.