We develop a banking model to explain the remarkable growth of China’s shadow banking since the global financial crisis. In the presence of local government interventions for low-quality projects due to short-termism, a policy combination of tightening formal banking and loosening shadow banking can reduce inefficiency given the information asymmetry between banks and regulators. This is because the higher funding liquidity risk of shadow banking incentivizes banks to be more disciplined about the quality of projects. We find consistent empirical evidence that when on-balance-sheet financing was constrained by regulators, banks shifted high-quality projects into shadow banking and rejected low-quality ones.