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.

China’s shadow banking system has experienced surprisingly high growth since the global financial crisis. We develop a model to understand this puzzling phenomenon. With local government interventions in bank loans for low-quality projects and information asymmetry between banks and regulators, a policy combination of tightening formal banking and loosening shadow banking can reduce inefficiency, 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 primarily shifted high-quality projects into their controlled shadow banking system.

In this paper, I build a continuous-time macro-finance model in which firms can access both bond credit and bank credit. The model captures the simple idea that the presence of bond financing increases the price elasticity of demand for bank loans. I find that the optimal capital adequacy ratio is quantitatively sensitive to the presence of bond financing and that models would overstate the banking sector's recovery rate if they omit bond financing. Furthermore, the model highlights that an economy's optimal capital requirement highly depends on the efficiency of its bankruptcy procedure and the risk profile of its real sector.

A model of the domestic financial intermediation of foreign capital inflows based on agency costs is developed for studying financial crises in emerging markets. In equilibrium, the banking system becomes progressively more fragile under imperfect prudential regulation and public sector loan guarantees until a crisis occurs with a sudden reversal of capital flows. The crisis evolves endogenously as the banking system becomes increasingly vulnerable through the renegotiation of loans after idiosyncratic firm-specific revenue shocks. The model generates dynamic relationships between foreign capital inflows, domestic investment, corporate debt and equity values in an endogenous growth model The model's assumptions and implications for the behavior of the economy before and after crisis are compared to the experience of five East Asian economies. The case studies compare three that suffered a crisis or near-crisis, Thailand and Malaysia, to two that did not, Taiwan Province of China and Singapore, and lend support to the model.

It is commonly argued that poorly designed banking system safety nets are largely to blame for the frequency and severity of modern banking crises. For example, “underpriced” deposit insurance and/or low reserve requirement are often viewed as factors that encourages risk-taking by banks. In this paper, we study the effects of three policy variables: deposit insurance premia, reserve requirement and the way in which the costs of bank bailouts are financed. We show that when deposit insurance premia are low, the monetization of bank bailout costs may not be more inflationary than financing these costs out of general revenue. This is because, while monetizing the costs increases the inflation tax rate, higher levels of general taxation reduce savings, deposits, bank reserves, and the inflation tax base. Increasing the inflation tax rate obviously raises inflation, but so does an erosion of the inflation tax base. We also find that low deposit insurance premia or low reserve requirements may not be associated with a high rate of bank failure.