Why do these exist and why do regulators tolerate them? As Zhang rightly points out and a few commentators observed post-Saradha, shutting down shadow banks can be done but amounts to shooting the messenger. The real culprit is financial repression. In the absence of high-quality, formal options to save, invest and borrow, people are forced to deal with the more “shadowy” segments of the financial system. In its extreme form, investments in financial assets of any form are rejected in favour of physical assets. In its Financial Stability Report, RBI acknowledges that “the shift from financial assets to real estate and gold has become stark. Inflation, low penetration of banking services, credibility of financial institutions in the wake of mis-selling of products and financial frauds, low post-tax returns on bank deposits, negative/low real interest rates etc could be some of the issues that need to be addressed to re-direct non-financial savings towards financial savings”.And the South China Morning Post
How interest rate controls created a shadow banking system in China
As a result, some depositors would like to receive a higher rate. At the same time, some borrowers and banks are willing to pay higher rates, because they can still make a profit on the higher rates. Thus the policy has created a shadow banking system paying a higher rate of interest than the official rate.
This is causing concern that these wealth management products are being used to "repackage old loans and prop up risky companies and projects", and that "shadow banking is helping drive the rapid growth of credit in a weakening economy, which could lead to - in the worst situation - a series of bank failures", the report said.This author seems to think that bribery and the black market for money will vanish with liberalization of interest rates. But there will always be borrowers who do not qualify at any interest rate who will bribe for a loan at all or to fudge the rate. State enterprise itself uses its position to obtain unreasonably low rates and always will. Interest rate liberalization will not end corruption, it will squeeze out the middlemen who are repurposing loans for an allowed activity into a banned one, which will remove a level of corruption from large projects. Just because interest rates can float doesn't suddenly mean small business is going to get loans from a state bank.