Liquidity Regulation and Unintended Financial Transformation in China

Kinda Cheryl Hachem, Zheng Michael Song

NBER Working Paper No. 21880
Issued in January 2016
NBER Program(s):   CF   EFG   ME

China began setting higher liquidity standards for its banking system in the late 2000s. This proved counter-productive: the interbank market became tighter and more volatile and credit soared. Our paper explains what happened and why. We first document that shadow banking emerged among China's small and medium-sized banks to evade the higher liquidity standards. We then argue that shadow banking poached deposits from big commercial banks and, in response, big banks used their interbank market power to try and undermine the shadow banks. A calibration of our model generates a quantitatively important credit boom and connects an otherwise disperse set of facts about China's rising financial system.