| Abstract | In recent years, the spectacular expansion of China’s shadow banking attracts broad attention from both academia and policy makers. Beyond traditional on-balance sheet bank loans and bond investment, how did shadow banking develop to a scale as high as RMB 5 trillion yuan? This paper systematically reviews development of shadow banking since 2002, and comes to conclude that shadow banking essentially is the financing vehicle of local government and real estate enterprises. Financing needs of these two types of enterprises are the essential driving factor of shadow banking growth. Incentive of commercial banks to lower transaction costs is also very important. Although shifting business off balance sheet, and externalizing internal transactions elevate funding cost, they substantially lower institutional cost and reduce total transaction cost. Besides, during this process, regulation policy also exerts influences. Based on the above analysis, we build partial equilibrium theoretical model and solve to obtain stock and price equations of shadow banking. For the first time, we utilize detailed aggregate data of China’s shadow banking from Li (2019) to conduct empirical tests of above analysis. The results from Instrumental Variable method, Generalized Method of Moments, and Vector Autoregression show that this explanatory framework stands at high significance level, and has strong explanatory power. |