Effect of interbank activities on bank risk: Why is China different?

Shadow banking commonly occurs outside the banking system to avoid regulation. However, in China, shadow banking could occur inside the banking system through interbank activities. This unique Chinese style of shadow banking provides a natural environment to examine how this form of banking, proxied by interbank activities, affects credit ratings. To prove this, we conduct two comparisons. First, we compare the local Chinese commercial banks with foreign bank subsidiaries in China where the two types of banks are subject to the same macroeconomic environments, policies, and regulations. However, unlike the local banks, foreign bank subsidiaries do not engage in the Chinese style of shadow banking. Next, we compare the interbank activities of five developed countries (Germany, France, Japan, the United Kingdom, and the United States) where the unique shadow banking system is absent. Our results show that credit ratings are downgraded for Chinese banks when they conduct interbank activities. The results do not hold for foreign bank subsidiaries in China as their ratings are either upgraded or show no effect from interbank activities. Furthermore, after we control for country heteroscedasticity, we find that agencies either upgrade ratings or keep them the same for the banks from the five developed countries that conduct interbank activities.