Capital chain rupture poses a major risk during China's economic transformation. No matter what regulation and supervision is imposed on the shadow banking system, it remains excessive or insufficient and a potential debt crisis looms as a result. Priority should be given to figuring out how to avoid the crisis.

To contain systematic financial risks, the State Council recently published guidelines geared toward strengthening regulations on shadow banking. The guidelines indicate the universal existence of shadow banking in the financial sector.

China has not yet built up a market-oriented credit system or an accompanying effective risk control system. Directed by governmental policies, shadow banking, which mirrors high liabilities, has blindly spread into industries like infrastructure construction and photovoltaic manufacturing. If not reigned in, shadow banking will find its way into urbanization, rural construction and environmental protection. Without a credit control system in place, some financial institutions tend to speculate, which could lead to financial collapse.

However, shadow banking can complement the traditional banking industry by smoothing enterprises' capital shortages and alleviating the negative effects of tightened policies on half-finished infrastructure projects. This explains why shadow banking cannot be completely wiped out.

The guidelines confirmed shadow banking as a product of financial development and innovation, a complement to the traditional banking system and a significant factor in diversifying investment channels.

However, to pursue huge profits, bodies that engage in shadow banking, such as pawnshops, micro-lending companies, financial leasing businesses and guarantee institutions, are scrambling to absorb deposits and lend out money at an exorbitant interest rates under the pretext of helping fund-hungry enterprises. These lending behaviors may destroy the existing financial ecology and force financial lending institutions to make profits like vampires sucking blood.

The guidelines make it clear how shadow banking institutions should be classified, who should supervise them, and how to keep them under control.

In the short term, strengthening supervision and regulation of shadow banks will put pressure on the profitability of financial institutions. According to the guidelines, commercial banks should follow the rules on capital withdraws and reserves, as well as separating funds used for discretionary account management from their own funds. Commercial banks are prohibited from purchasing loans issued by themselves or setting up capital pools for financial management. Security companies should reinforce management of net capital, while insurance companies should improve solvency. All these together will squeeze bank profits and urge them to replenish core capital.

These are helpful, but the focus should be on establishing a strict credit mechanism during China's market-oriented reform and adopting a credit risk pricing method. As long as there is no pricing system in place, systematic risks will linger. Only when financial institutions can help screen out quality low-risk enterprises, rather than bleeding the real economy or being manipulated by governmental policies, can they get rid of systematic risks completely.

Chinese enterprises have high debt ratios. Shen Minggao, Citibank's chief economist for the Greater China region, said that the debt ratio of China's small and medium-sized enterprises has hit 120 percent, the highest in the world.

Shadow banking should not be blamed for financial risks. The culprits are the disordered credit system and administrative interference.

In summary, financial reforms should allow the market to help credit mechanisms take shape.

This is an edited excerpt of an article by Ye Tan, a financial commentator, published in National Business Daily