Shadow banking is growing rapidly in a number of developing countries, including China, where it recently was estimated to increase from approximately 40% of that country’s gross domestic product at the end of 2014 to approximately 78% of GDP at the outset of 2016. In a recent paper, available here, I analyze the regulation of shadow banking in China and other developing countries.

Shadow banking refers loosely to the provision of financing outside of traditional banking channels, including not only non-bank intermediated financing, such as securitisation and securities lending, but also the provision of financing by banks using non-traditional means. Estimated at $67 trillion worldwide, shadow-bank financing appears to dwarf traditional bank financing.

China has the world’s highest rate of growth in shadow banking. Shadow banking has been especially important there as a source of funding to small and medium-sized enterprises, including entrepreneurial start-up companies, because Chinese banks have not readily extended credit to those companies. Chinese shadow banking includes peer-to-peer business lending, accounts receivable factoring to provide liquidity to vendors of goods, and wealth management plans in which customers entrust funds with their bank, which then uses the entrusted funds to invest in a pool of securities—functionally no different than an investment in a mutual fund. More recently, Chinese shadow banking has expanded to the Internet, inspired by the government’s plan intended to drive economic growth by integrating Internet technologies with manufacturing and business.

In developing countries outside of China, the main shadow-banking players tend to be quite diverse. They include finance, leasing, and factoring companies, investment and equity funds, insurance companies, pawn shops, and even underground entities.

The changing details of shadow banking are less important than the fact that it reflects non-bank, or at least non-traditional-bank, intermediated financing. For that reason, and also because of its relative novelty, shadow banking is not always adequately regulated. Chinese shadow-banking regulation also faces an additional impediment. Although China now has an overarching framework for regulation, the governmental regulator (banking, securities, or insurance) that approves the establishment of a shadow-banking entity is theoretically responsible for regulating it. Commentators remain dubious of the framework’s effectiveness because (among other reasons) similar financial products are sometimes subject to different regulators.          

How should shadow banking be regulated? Because it currently tends to be much less regulated than traditional banking, shadow banking is to some extent driven by regulatory arbitrage. That does not necessarily mean that shadow banking should be subjected to more regulation. It sometimes might reflect, for example, that traditional banking should be subject to less regulation.     In deciding how to regulate shadow banking, it is important to recognize that shadow banking has the potential to increase economic efficiency but also to increase risk.

Shadow banking can increase efficiency through disintermediation and decentralization. Disintermediation refers to the distinguishing feature of shadow banking: providing financing outside of traditional banking channels. This helps companies avoid having to pay the profit markup that intermediary banks would otherwise charge on traditional products, such as loans. Shadow banking can additionally increase efficiency by diversifying, and thus decentralizing, the provision of financial products and services. It thereby can provide financing to underserved constituents, such as the small and medium-sized enterprises mentioned. A decentralized financial system may also be more robust in the face of economic shocks.

But decentralization can also increase risk. It may be relatively harder, for example, to control market failures, or there could be more such failures. Decentralization might also make it more difficult for market participants to effectively process information, allowing risks to accumulate unnoticed and unchecked, which can cause panics. Additionally, because non-bank shadow banking participants are unregulated or lightly regulated compared to banks, they might be more likely to fail, impacting traditional banking through contractual (or other) relationships.

Shadow banking thus can operate as a double-edged sword, increasing both efficiencies and risks. The challenge for regulation is to minimize those risks while maximizing, or at least not significantly impairing, those efficiencies.

Steven L Schwarcz is the Stanley A Star Professor of Law & Business at Duke University.