Shadow Banking in China
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Shadow Banking in China

Risk, Regulation and Policy

Shen Wei

This timely book investigates the dynamic causes, key forms, potential risks and changing regulation of shadow banking in China. Topics discussed include P2P lending, wealth management products, local government debts, and the underground lending market. Taking policy considerations into account, the author provides a comprehensive analysis of the regulatory instruments tackling the systemic risks in relation to China’s shadow banking sector. Central bank’s role, interest rate formation mechanism, exchange rate reform and further deepening reform of the regulatory regime and financial markets are also thoroughly discussed in the context of China’s continuing financial reform.
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Chapter 8: Removing underground lending markets out of the shadows

Shen Wei


The informal or underground lending market is made up of private money lenders, loan sharks or pawnshops, which provide an additional source of capital for households or entrepreneurs. These financing institutions are not licensed or supervised by a regulatory or supervisory authority, which distinguishes them from formal lending institutions. Serving households and small enterprises is a high-risk and high-cost business for banks for their higher transaction costs, unstable income streams or low capabilities to repay the debt. As a result, lending to these borrowers may involve higher default risks due to the lack of sufficient collateral or credit information. However, the strong demand from these borrowers to gain access to capital creates a demand-side of the informal lending market which deepens market segmentation and pushes up higher interest rates. The informal lending sector is large in some emerging Asian economies. In India, the underground lending market is as large as 36% of GDP while the formal banking sector accounts for 52% of GDP. In Thailand, the formal and informal lending sectors are 118% and 47% of GDP respectively. This chapter focuses on the informal (or underground) lending market, which not only supplements the formal financial system by serving the lower end of the market but also accumulates the potential risks further eroding the efficient financial market. The rest of the chapter proceeds as follows. Section 1 analyses the basic concepts of underground lending and informal lending along with their economic justifications. Underground lending is a severe economic phenomenon in China and the on-the-ground reality, in particular, the recent runaway crisis caused by the serious defaults in the underground lending market will be discussed. Section 2 tries to understand the nature of risks involved in the underground lending market and the government responses to such risks. The government’s traditional approach can be understood through a study of the Wu Ying case. Underground lending businesses can easily be caught upon by the criminal liability of illegal fundraising, which was crafted based on the financial repression doctrine. Section 2 analyzes the logic of criminal liability attached to illegal fundraising. Section 3 and Section 4 focus on two new responses to the runaway crisis caused by the frequent defaults in the underground lending market. The government makes an attempt to legitimize and formalize part of the underground lending market through local experimentation in Wenzhou. Meanwhile, the Supreme People’s Court is liberalizing its previous rigid judicial attitudes towards contract-based interest rates in private lending. These two responses are important to understand the liberalizing trend in China, switching its financial market from financial repression to financial liberalization. Section 5 is a brief section discussing China’s open-up of its financial market to private investors. A short conclusion ends in Section 6.

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