China's Central Bank Issues Warning

Chinese banks have faced turbulent waters recently due to risky lending techniques. In what is called the shadow banking system, Chinese banks lend to smaller banks and trusts, who in return make loans with these funds. This additional lending is usually riskier.

China’s central bank announced Monday that the banks need to participate in more responsible activities and manage their cash better, according to the New York Times. This announcement to the public comes after the banks were notified last week. This caused China’s SHIBOR to surge and interbank lending to stall.

The United States underwent a similar situation during the subprime mortgage crisis when banks stopped lending to each other. The United States temporarily resolved this problem by opening up lending from the federal government.

Short disruptions in the interbank lending system can have significant effects on the economy. Lending of this nature is necessary to support the reserve banking system, where banks can lend money deposited, and if cash supplies fall at a particular bank, it can borrow funds from another in the short run to satisfy demand for withdrawals. When this system fails, people cannot withdraw funds from their accounts, and panic ensues.

As the New York Times points out, a significant amount of bad debt is likely hidden in this shadow banking system. Even without this debt, the Chinese economy is facing the slowest growth year in more than two decades.

After crashing more than five percent yesterday, the Shanghai index lost 0.19 percent in today’s trading session.