The Toronto-Tsinghua International Law Conference examined the threats—and possible solutions—to the rise of unregulated ‘shadow’ banking in China and the U.S.

Toronto-Tsinghua conference illustration

By Peter Boisseau / Illustration by Beppe Giacobbe

From the Fall/Winter 2014 issue of Nexus.

Lawmakers and regulators around the world are grappling with the explosive growth of poorly regulated “shadow banking” sectors in China and the U.S. that provide easy credit and high returns—but have become so large, they may also pose the threat of a global economic meltdown, a University of Toronto law conference was told.

Shadow banking now represents “about a quarter of all financial assets internationally,” making it a “huge portion” of the global economy, Faculty of Law student Michael Rosenstock, 3L, said in a presentation Oct. 17 to the Toronto-Tsinghua International Law Conference, which brings together faculty from both universities to explore legal issues from Chinese and North American perspectives.   

Widely seen as a catalyst for the 2008 financial crisis and the global recession that followed, shadow banking refers to institutions and markets, such as mortgage companies and mutual funds, that provide loans and financial services which are far less regulated than the mainstream banking sector.

The need for better information and cooperation among domestic and international regulators was a common theme of the conference. Economies around the world are closely connected, and analysts increasingly see the breakneck growth of shadow banking in emerging markets like China as a potential threat to global financial stability.

To counter that threat—which could spread to affect jobs and investments worldwide— the pace of regulatory reform in emerging markets must keep pace with that in developed markets, analysts say. To make that possible, finance and business-conduct regulators must coordinate their efforts.

While G20 leaders have agreed to strengthen regulation of shadow banking, they are still a long way from creating an effective regulatory framework that is meaningful to different countries, Simin Gao, assistant professor at Tsinghua University School of Law, told the panel. Her presentation outlined current factors that could trigger “systemic contagion” in China, the world’s second largest economy.

Gao said some critics even suggest U.S. laws drawn up after the last financial crisis could create regulatory arbitrage—allowing companies to exploit loopholes created by inconsistent regulatory systems and uneven application of finance and business laws.

Meanwhile, “the Chinese property market is looking like the Titanic headed in the direction of an iceberg,” she said. As relatively immature, inexperienced players in hedging risk compared to their American and European counterparts, Chinese shadow banking institutions are more vulnerable to shocks in financial markets, she added.

Figures suggest the U.S. has the world’s largest shadow banking sector and China’s is the fastest growing. A study comparing shadow banking in the two vastly different economies—one sophisticated, the other still emerging—could prove fruitful, she said.

State-controlled capital markets are underdeveloped and the private sector—the most energetic part of the Chinese economy—has stepped in, said Gao. They are circumventing repressive financial regulations, supplying savers and investors with higher returns and extending credit to small businesses unable to obtain loans from mainstream banking.

Most of the products in China’s shadow banking system are simply versions of deposits and loans, functioning “exactly like traditional banks,” she said.

Chinese financial regulators are in a dilemma. They want to develop deep and versatile capital markets, and shadow banking plays a role in that. But they are walking a tightrope between encouraging new capital markets and controlling them.

“Before 2014, there was almost no appropriate regulation of shadow banking in China, and it was simply excluded from the regulatory regime,” said Gao. New laws were recently enacted requiring regulators to work together on shadow banking, but poor coordination is plaguing efforts to mitigate its risks and promote its merits.

Different regulators working separately to try to grapple with system-wide problems is not efficient, she said. As regulators “pass the buck from one to another,” the shadow banking market in China remains inadequately regulated.

At the same time, it’s important to recognize “shadow banking is driven not only by regulatory arbitrage but also by genuine market demand,” said Gao. Whatever its differences in sophistication, shadow banking in both the U.S. and China fills the same demand for access to services, credit and higher returns unavailable in regular banking.

Gao noted that here is an opportunity to make good use of shadow banking’s benefits while reducing its risks, if the pent-up demand for credit and the legitimate reasons why it exists is taken into equal consideration with the need to regulate its conduct.

Balancing those two realities can not only answer questions about why there are large shadow banking systems in the U.S. and China, but may also generate lessons for other countries as well, giving the international community a framework for new policy, she concluded.

Rosenstock, her fellow panelist at the conference, is co-author of Institutional Design and the New Systemic Risk in Banking Crises, together with U of T Law’s Prof. Anita Anand and Prof. Michael Trebilcock, Chair in Law and Economics.

Shadow banking is one area examined in the paper, along with credit rating agencies, derivatives and asset-backed securities, where public policy makers have established new regulations to mitigate some threats.

The classic understanding of systemic risk, where a domino effect is created after one bank defaults on a loan to another, continues to evolve, Rosenstock said.

No regulatory body can foresee with certainty all the kinds of systemic risk that will arise.  “The focus is on what regulatory architecture is available to best address and mitigate systemic risk, as we now see systemic risk.”

In domestic markets, the authors favour an objectives-based model of regulation. Under such a model, one set of regulators can focus on prudential aspects of banking, insurance and securities while another focuses on the business conduct of those sectors, for example.

“Our paper concludes that the benefit of the objectives-based approach—where you regulate by objective—is that you facilitate the coordination and information sharing that’s really necessary for regulating and mitigating the new systemic risk,” he said.

On an international scale, a regulatory framework that provides no consistent bulwark against systemic risk and financial crises may even exacerbate such problems if countries fail to comply, creating the possibility of regulatory arbitrage, he said.

Rosenstock said the authors of his paper instead favour “modest proposals” to increase compliance and coordination among international economic actors, including a memorandum of understanding (MOU) between domestic regulators.

They also suggest a continued emphasis on “soft law” and non-binding agreements, coupled with best practices to achieve coordination and harmonization, built upon the compliance systems within existing international agreements.

While change may be necessary, that doesn’t make it any less arduous. “Massive change in institutional architecture is costly and difficult and there is a certain path dependency in every country,” said Rosenstock. 

“We can say that there is a certain structure that states should enter into, but we also know that is not easy and may not even be possible.”