By staff reporters Wang Peicheng and Zhao Jingting

A debate over the scale and systematic risk of China's shadow banking system has heated up over the past two months, putting banking regulators in the hot seat.

In the past several weeks, a number of ministerial-level officials including China Banking Regulatory Commission (CBRC) Chairman Shang Fulin have stated the risk and scale of so-called shadow banking have been largely exaggerated.

Based on different estimates, the total scale of shadow banking in China can be anywhere from 5 trillion yuan to 40 trillion yuan. Risk classification and regulatory challenges may be inherently different depending on the overall size of the shadow banking system.

Most central bank officials and financial industry research analysts agree that shadow banking does not exist in China according to the international definition. However, they have recognized the objective existence of a hybrid financial business type known as "Chinese shadow banking."

Zeng Gang, director Institute of Finance and Banking, Chinese Academy of Social Sciences (CASS), came up with a definition for Chinese shadow banking which has been recognized by most of the financial sector. Zeng defines it as any entities or activities involving financial intermediation or credit creation which have similar credit, term, and liquidity transformation functions of traditional banks but have systemic effects and fall outside the scope of normal banking supervision.

Based on this definition, the central bank's discussion is not limited to financial stability, but instead extends to areas such as Chinese shadow banking's interference with monetary policy and macro-control, money creation, and potential rescue mechanisms in case of a risk outbreak.

In the past few years, the rapid expansion of Chinese shadow banking as a disguised form of credit products has injected a large amount of capital into the real economy, fixed market distortions caused by unsound financial regulation, and improved the service efficiency of the financial system. Total social financing in China reached 15.76 trillion yuan in 2012, of which non-bank credit accounted for 48 percent. The proportion of non-bank credit has increased year after year, the vast majority of which can be classified as Chinese shadow banking.

Diversified financing needs outside of non-bank credit will remain strong in 2013, with further expansion expected. In other words, the scale of Chinese shadow banking will continue to grow.

It is undeniable that the opportunistic expansion of Chinese shadow banking is closely related to the orientation of macro-control and industrial policy and is inherently geared towards circumventing supervision. Shadow banking, by its very nature, is a credit intermediary. The resulting expansion in credit has brought about a rise in the supply of social credit, short-term borrowing for the purpose of long-term financing, higher financing costs, and a rise in the total debt ratio of enterprises. If it is allowed to accumulate for the long term, at some point in the future the potential financial risk of Chinese shadow banking will transfer to the real economy.

Ji Zhihong, director of the Research Bureau of the People's Bank of China, said that attention on Chinese shadow banking should focus not only on the micro level but also on the resulting rise in the overall corporate debt ratio. Industry analysts suggest regulatory authorities and decision makers consider appropriate reform of the financial system and regulatory optimization, as the expansion of business areas in the Chinese shadow banking system coincides with deregulation and deepened reform of the financial sector.

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