Policy Brief 13-14: Shadow Deposits as a Source of Financial Instability: Lessons from the American Experience for China

Th e fi nancial regulation architecture in both the United States and China developed during eras when retail deposits and bank loans were the primary mode of fi nancial intermediation. Th e function of banks is to transform short-term deposits into long-term loans, while providing liquidity for depositors. Experience has taught regulators hard lessons that this activity must be subject to prudential safeguards, including reserve requirements, principal protection for depositors, and access to a lender of last resort. Without these protections, short-term deposits are subject to bank runs that can destabilize the entire fi nancial system. Over the years, however, fi nancial innovations have led to the buildup of short-term pools of funding outside the confi nes of these protections. Th ese shadow deposits play a role similar to traditional deposits, taking short-term funds from individuals and businesses and providing credit to borrowers. In the United States, shadow deposits take the form of money market mutual funds, deposit-like funds that are not protected by deposit insurance, lack capital buff ers, and are off ered by institutions without access to the lender of last resort. In China, shadow deposits are wealth management products, short-term fi nancial products off ered as an alternative to traditional savings deposits, most of which are principal unguaranteed and thus lack the implicit government support enjoyed by traditional deposits. In both countries the origin of shadow deposits was regulatory arbitrage, giving ordinary investors a way to bypass the restrictions placed on traditional deposits. Th e controlled interest rates on traditional deposits in both the United States and China fell below prevailing market rates. Shadow deposits emerged as a way to off er savers the convenience and perceived safety of a deposit while off ering a higher interest rate than that earned on traditional deposits. Th ey can off er these higher rates precisely because they are exempt from many of the costly safeguards put upon banks. Shadow deposits have grown into an important source of funds in both the United States and China, particularly in the short-term fi nancing markets. Th ese deposits are also the component of the shadow banking system where ordinary investors are most likely to be involved. While money market mutual funds were thought for decades to be relatively safe and boring, the global fi nancial crisis forever altered this perception. Relatively small losses in the commercial paper market precipitated a run on …