In the next five years, the top risk to China's financial market is the country's shadow banking system, as Xiao Gang, President of Bank of China, recently predicted in an article. Xiao believed that quite a few financial products released by Chinese commercial banks are Ponzi schemes, a fraudulent investment operation that pays returns to its investors from the money paid by subsequent investors, rather than from profit earned by the individual or organization running the operation.

Some foreign economists suggested the risks brought by shadow banking to the Chinese market had been substantially underestimated. Currently, the debate centers on how to regulate the shadow banking system and control its size and how to achieve a balance between financial innovation and regulation, but should be focused on understanding its nature and potential risks.

In short, shadow banking can be described as financial intermediary activities occurring outside or partially outside the banking system, but involving maturity transformation and leverage. Instead of being credit intermediation paralleling or detached from core business of traditional banks, shadow banking encompasses a series of financial activities, markets, contracts and institutions, which get interconnected through business and evolve into a chain of credit expansion.

No matter how shadow banking operates, in essence, it is a process of infinite credit expansion. It can take the form of non-bank credit expansion between the financial system and real economy, as well as various kinds of credit expansions inside the financial system. If regulators fail to identify various kinds of credit expansions and constantly improve financial supervision rules, different kinds of shadow banking may trigger financial crises at any time, just like the 2008 financial crisis, which was caused by a securitization-led shadow banking system.

It has been estimated that the scale of shadow banking in China reached 30 trillion yuan ($4.82 trillion) in 2012. Two thirds of the 3-trillion-yuan ($481.8 billion) total social financing in 2012 came from shadow banks, most of which entered the domestic housing market and local government financing vehicles with interest rates of more than 15 percent (the benchmark interest rate is 6 percent).

Looking into the financing sources of real estate development, bank loans merely accounted for 10 percent, while self-pooled funds make up more than 50 percent.

Evidently, shadow banking in China, although taking different forms from that in the United States and Europe, is actually a kind of excessive credit expansion. In recent years, shadow banking has not only expanded its scale, but has also become difficult for regulators to identify and supervise.

At present, the risks of shadow banking have not yet been fully exposed. For one thing, housing prices continue to rise after a boom spanning almost 10 years. As long as housing prices keep surging, the real estate market will maintain huge profits, and high-cost and highly leveraged funds will continue flooding in. In fact, large inflows of funds into the real estate market from shadow banking have accumulated huge financial risks. For another, the quantitative easing monetary policy adopted by the United States and European countries will not change in the short run, so speculators will not cease investing in the real estate market.

However, it is impossible for the two preconditions to sustain. Now, domestic real estate developers continue to push up housing prices under the pretext of urbanization. The government should unveil policies to adjust housing prices to improve people's livelihood and the quality of urbanization. There are also signals that the quantitative easing will not last for a long time. Ben Bernanke, Chairman of the U.S. Federal Reserve, can only serve for another year, which adds to the uncertainty of America's future monetary policies. Once market sentiment turns, risks in the domestic shadow banking system will immediately emerge.

This is an edited excerpt of an article by Yi Xianrong, a research fellow of the Institute of Finance and Banking at the Chinese Academy of Social Sciences, published in Shanghai Security News.