Shadow banking and the bank lending channel of monetary policy in China

We study how shadow banking affects the effectiveness of monetary policy in China. Using novel data on bank-issued off-balance sheet wealth management products (WMPs), we show that banks improve their on-balance sheet risk profile by issuing WMPs. This in turn lowers the sensitivity of banks’ wholesale funding cost to monetary policy and reduces the effectiveness of the bank lending channel. The effect of our mechanism on total credit is quantitatively similar to the effect arising from the substitution between traditional loans and shadow banking loans previously analyzed in the literature. The channel documented in this paper has novel implications for the regulation of banks’ off-balance sheet activities and market-based funding.