Liquidity Regulation and Unintended Financial Transformation in China

Abstract

China increased bank liquidity standards in the late 2000s. The interbank market became tighter and more volatile and credit soared, contrary to expectations. To explain this, we argue that shadow banking developed among Chinaʼs small and medium-sized banks to evade the higher liquidity standards. The shadow banks, which were not subject to interest rate ceilings on traditional bank deposits, then poached deposits from big commercial banks. In response, big banks used their substantial interbank market power to restrict credit to the shadow banks and increased their lending to non-financials. A calibration of our unified framework generates a quantitatively important credit boom and higher and more volatile interbank interest rates as unintended consequences of higher liquidity standards.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

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