Study reveals how China's monetary policy fuels shadow banking and bank risk

New research employing advanced machine learning techniques reveals that China's collateral monetary policy has significantly stimulated shadow banking growth while increasing bank risks. The study finds this policy creates liquidity distribution distortions, with non-primary banks being particularly vulnerable. Importantly, the 2018 New Asset Management Regulation effectively mitigated these effects, demonstrating the value of targeted regulatory interventions.

Background and Motivation

Over the past decade, China's shadow banking system has experienced substantial growth alongside the implementation of collateral monetary policy. However, the intricate relationships between monetary policy instruments, shadow banking activities, and bank risk exposures remain inadequately understood. This research addresses this critical gap by investigating how collateral requirements distort liquidity allocation and subsequently impact financial stability.

Methodology and Scope

The study employs innovative SHAP-Bayesian-XGBoost machine learning methods to analyse the complex interrelationships between collateral monetary policy, shadow banking, and bank risks. By combining the predictive power of XGBoost with SHAP's explanatory capabilities, the research effectively uncovers the "black box" of how monetary policy transmission mechanisms influence shadow banking dynamics and risk accumulation within China's banking sector.

Key Findings and Contributions

The analysis reveals four key insights: collateral monetary policy stimulates shadow banking growth through liquidity distribution distortions; this stimulation subsequently increases bank risks; non-primary banks demonstrate heightened sensitivity to these policy effects; and the 2018 NAM Regulation successfully mitigated the policy's stimulative impact on shadow banking and associated risks. The research makes a significant contribution to understanding monetary policy transmission in emerging financial systems.

Why It Matters

These findings illuminate the unintended consequences of collateral-based monetary policy frameworks in developing financial markets. The research demonstrates how well-intentioned policy tools can create systemic distortions, while also showing that carefully designed regulations can effectively counteract these adverse effects, offering valuable lessons for global policymakers facing similar challenges.

Practical Applications

• Central banks should consider the shadow banking implications when designing collateral frameworks.
• Regulators can implement targeted measures similar to the NAM Regulation to curb policy-driven risk accumulation.
• Financial institutions, particularly non-primary banks, should enhance risk monitoring of shadow banking exposures.
• Policy makers should account for institutional heterogeneity when designing macroprudential measures.

Discover high-quality academic insights in finance from this article published in China Finance Review International. Click the DOI below to read the full-text original!