This study examines the effects of shadow banking on bank efficiency using data on Chinese commercial banks during the period 1998–2012. I focus on two aspects: shadow banking activities inside and outside the commercial banks. Stochastic frontier analysis (SFA) is used to analyze the effects of shadow banking on cost-efficiency. The empirical results indicate that the higher relative size of shadow banking inside the commercial banks, the higher bank cost-efficiency is, while the higher relative size of shadow banking outside the commercial banks, the lower cost-efficiency is. This shows that there are gains from shadow banking for the Chinese financial system. It is important for policymakers to realize this but at the same time understand that shadow banking likely implies a trade- off between flexibility for the banking sector and higher risks.

Keywords: Shadow banking; Cost-efficiency; Chinese commercial banks; Stochastic frontier analysis