Law and finance in the Chinese shadow banking system

Abstract

Almost twenty years after economists Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny published their ground-breaking and controversial research examining the relationship between investor protection laws and stock market development, our understanding of the relationship between law and finance is still in its theoretical infancy. Today, few would argue that strong laws do not help generate credible commitments and thereby promote financial development. Ultimately, however, this observation is little more than a useful starting point for exploring the complex, dynamic, and structurally interdependent relationship between law and finance within modern financial markets.So where might we turn for further insights into this important relationship? One potentially useful framework is the 'Legal Theory of Finance' (LTF). At the heart of LTF are four interwoven propositions. These propositions emphasize the legal construction of financial markets, their essential hybridity and inherent hierarchy, and the role of the law as not only a mechanism for generating credible commitments, but also as a potential source of financial instability. LTF thus both complements and expands upon conventional frameworks for understanding the relationship between law and finance. This Article uses LTF to explore the emergence, growth, and risks residing within a little known but increasingly important segment of the Chinese shadow banking system: the $USD2 trillion dollar market for wealth management products (WMPs). WMPs possess a number of distinctive legal and economic features. First, despite being marketed by banks and other intermediaries as substitutes for conventional deposit accounts, the liabilities generated by the majority of these products do not reside on bank balance sheets. Second, while WMPs typically lock-in investors' capital for relatively short periods of time, this capital is often invested into less liquid, longer-term assets. The resulting maturity and liquidity mismatches thus recreate the fragile capital structure of banks. Third, WMPs have emerged largely in response to China's interventionist approach toward both banking regulation and broader macroeconomic policy. As we shall see, LTF holds out a number of important insights into the emergence of WMPs, their legal structure, their dramatic growth in the wake of the financial crisis, and the risks they may pose to financial stability. More broadly, understanding WMPs through the lens of LTF highlights the fact that, far from simply representing the 'rules of the game,' the law is also often the board, the game pieces, and the dice