Ironically, it is the iron grip of the state regulatory and supervision apparatus over the countrys financial system that spawned the shadow financing sector and has fanned its growth. Commercial banking is dominated by state-owned banks that are tightly regulated in virtually every area right down to the meagre interest rates they are permitted to offer depositors. Being bureaucratic, state-run institutions, Chinese banks prefer doing business with other state-owned businesses, which means private enterprises are shut out. These conditions created the ideal environment for shadow financing to thrive, filling the void left by state banks for unmet demand for credit. The government has been battling to rein in a credit-fuelled investment boom unleashed as a result of stimulus aimed at warding off the global financial crisis. Unfortunately, a 2009 clampdown on out-of-control bank-lending not only failed to cool credit growth but inadvertently ignited a massive expansion in shadow financing. The sector consists of investment bank-like trust companies, brokerages, financial guarantors, insurers, micro-lenders, corporates, pawn-shops and individuals all engaged in the extension of credit. Shadow financing is easier to obtain but typically far more expensive than that available in the tightly regulated banking sector, making it a natural fit for capital-chasing higher yields. The government has become worried about the sectors size and lack of transparency, with shadow financing now thought to account for half of overall credit growth in the economy. The agency responsible for supervising the banking sector, including shadow banking, is the China Banking Regulatory Commission (CBRC). The agency has wide-reaching powers over the state-run banks, but when it comes to shadow financing its reach is more limited. For example, inter-company loans or peer-to-peer lending are difficult to detect, let alone regulate. CBRC has been making concerted efforts with a series of measures aimed at strengthening existing shadow banking regulations and extending its reach to achieve some form of supervision over segments presently beyond its control. However, any joined-up approach to shadow financing is hampered by regulatory overlap with other agencies. The Peoples Bank of China, for example, sets the all-important loan-to-capital ratio and controls liquidity. And while trust companies come under the CBRC, securities companies are regulated by the China Securities Regulatory Commission (CSRC), and insurance companies by the China Insurance Regulatory Commission (CIRC). And one must not forget the politicians. As with many areas in China, policy goes hand in hand with regulation, meaning the state council also dishes out its own directives. On the ground, supervision and licensing falls to local governments, which have something of a conflict of interest. While they are prohibited from direct borrowing, they have managed to accumulate at least Rmb10.7 trillion ($1.75 trillion) debt through special purpose financing vehicles and borrowing from trust companies. This has gone mostly to fund infrastructure projects but also speculative projects, including real estate. For now, regulators appear to have taken the expedient decision to focus their efforts on the banks, not just because it is the easiest route given the level of control they exert over state banks, but because banks are up to their necks in shadow financing themselves. Chinese banks are used to obeying the state councils directives, but at the same time if an activity is not specifically banned or the current regulation has loopholes, they would gladly engage in this activity if they deem it profitable, says Diana Choyleva, director and China specialist at Lombard Street Research in Hong Kong. Banks might hold controlling stakes in trust companies, which therefore look to the parent for funding since they cannot accept retail deposits. Large state-owned companies obtain cheap bank loans which are rate-capped and then lend the funds on to SMEs at a higher interest. As a result, the quality of these loans is placed at risk from the lending daisy chain. Then there are the wealth management products (WMPs) provided by shadow banks to fund projects and pay their other investors but marketed by banks, off balance-sheet. These are mostly short-term savings products that offer much better rates of interest than those on offer from banks but without the implicit guarantee of deposits in a government-owned bank. Many of the assets underlying WMPs are real estate or long-term infrastructure projects that are unlikely to generate sufficient cash flow to keep up repayments. Last year, Xiao Gang, former chairman of the largest state bank Bank of China, who now heads the CSRC, said the WMP segment was to some extent, fundamentally, a Ponzi scheme. However, banks the world over have long-term investments on their books funded by short-term deposits. The CBRC has recently turned its attention to trying to slow WMPs growth to assist the wider goal of limiting funding to the shadow banking sector. Trust companies, which are under the supervision of the CRBC, were recently ordered to report all loans to the regulator. In March, financial institutions were ordered to notify it of all funds raised for local governments, including cash from the sale of WMPs. Local government projects and investments are driving much of the credit growth. At the same time, CBRC, as part of a tightening of rules covering the sale of WMPs, announced new standards requiring banks to clearly identify the assets in which proceeds from WMPs are invested. Banks will have to set aside provisions for losses for outstanding WMPs that do not comply with the new standard by the end of the year. CBRC has also set a 35% limit on the proportion of total WMP proceeds banks are permitted to invest in trust company loans and other risk products, or 4% of a banks total assets. These measures are an important step to improve the stability of the sector in the long term, says Capital Economics chief Asia economist Mark Williams. Previously, it was very unclear who would bear the losses if the underlying investments went bad. But they need to be quite careful with how they regulate because its important not to stifle growth of shadow banking because, after all, a more diversified financial sector is in Chinas long-run interests. China doesnt want to go back to having a financial system that is made up of large state-owned banks and very little else. The benefits that a diversified financial system can deliver can easily be forgotten at times like this when people are trying to limit the risks. Chinas regulatory system was built for another age when the different parts of the financial system were separate but now that theyre increasingly inter-linked theres a risk of things falling through the gaps. Williams concludes: Theres some serious thinking going on in Beijing about how best to regulate the financial sector, including the possibility of creating a super-regulator that would combine the CBRC, CSRC and CIRC.