China’s Financial Network with International Spillovers: A First Look (Summary)

During the 2015–16 turmoil in China’s stock market, which is the second largest in the world, investors worldwide feared for another global financial crisis. Understanding how financial shocks spread among financial institutions remains key to preventing such crises, developing regulation, pricing assets, and managing risk. Offering further insights into China’s financial system, this study sheds new light on the Chinese banking system’s influence in the countries with the world’s four largest global financial services sectors—the United States, the United Kingdom, Germany, and Japan—with Japanese banks the most affected by shocks within China. It also explores the role of non-bank institutions in transmitting financial shocks, highlighting the influence of “shadow banking”—the phenomenon of financial services provided by unregulated institutions.

The authors of this study use a modified financial network analysis to examine the network structure and possible influences of financial shock transmission among China’s financial institutions since the 2008 global financial crisis. The authors control for the interactions between China and the aforementioned four countries. The authors define systemically important financial institutions (SIFIs) as those having the most influence on other financial network institutions. An institution’s comparative importance is determined according to its level of influence on others and its net influence in the financial shock transmission network.

As in prior studies, the authors use an empirical approach that reveals how financial institutions are interconnected beyond their visible business ties and thus transmit risk. They use daily stock return data to quantify the financial shock transmission network among China’s financial institutions. The authors collect data from the China Stock Market & Accounting Research database, including the daily closing prices of the financial sector companies traded on China’s A-share stock market. The sample period from January 2008 to December 2015 contains observations for 51 financial institutions, including banks, non-banks, and insurance companies. The authors’ approach is built on the forecast error variance decomposition of generalized vector autoregression, which measures connectedness to allow exploration of the networks.

This research helps increase understanding of China’s financial system and comprehensively analyzes the drivers of financial shock transmission in the economy. The authors document that the large commercial banks often play a more pronounced role in the financial shock transmission network than do China’s Big Four state-owned banks, despite the prevalence of the latter in the economy’s banking system. This study also suggests the need to reevaluate the approach of identifying SIFIs based on relatively low-frequency financial data, given that low-frequency studies do not capture the dynamics of shock transmission over time and market conditions. The documented pattern of interconnectedness between China’s financial sector and those of the other four major global economies also implies that any policy intervention in any one of these nations’ financial sectors may spill over to the others.

Both firm-specific and macroeconomic factors influence the degree to which financial institutions receive or disseminate financial shocks. Those factors include money supply, interest rates, and the value of the Chinese currency, as well as size, profitability, short-term-debt-to-total-asset ratio, and liquid-asset-to-total-asset ratio.

For market practitioners, particularly those who influence policy decisions, this research offers a robust understanding of how policy decisions in one economy may affect others. As the global economy continues to become increasingly interconnected, having this coordinated understanding will be essential to navigating future financial crises.