Shadow banking in China is mainly conducted by commercial banks to evade regulatory restrictions on deposit rate and loan quantity. It essentially constitutes a dual-track pragmatic approach to gradually liberalize the country's repressed interest rate policy. We show in equilibrium that shadow banking improves social surplus given high deposit reserve requirement and inefficient bond market. Full interest rate liberalization leads to additional gain in social surplus. The dual-track approach

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... interest rate liberalization avoids the potential economic turbulence caused by an otherwise single-track one-step approach. JEL Classification: E42, E43, E51, G18, G21, G28. Abstract Shadow banking in China is mainly conducted by commercial banks to evade regulatory restrictions on deposit rate and loan quantity. It essentially constitutes a dual-track pragmatic approach to gradually liberalize the country's repressed interest rate policy. We show in equilibrium that shadow banking improves social surplus given high deposit reserve requirement and inefficient bond market. Full interest rate liberalization leads to additional gain in social surplus. The dual-track approach to interest rate liberalization avoids the potential economic turbulence caused by an otherwise single-track one-step approach. JEL Classification: E42, E43, E51, G18, G21, G28.