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| Financial Decentralization, Credit Misallocation, and Local Small and Medium-sized Banks' Risks |
| XIAO Rui, AI Sijing, HONG Zheng
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| Institute of Chinese Financial Studies, Southwestern University of Finance and Economics |
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Abstract China has been making substantial efforts to prevent and mitigate financial risks in key fields in recent years. As a critical part of these efforts, the reform and risk reduction of small and medium-sized financial institutions have achieved significant milestones. However, potential risks remain pronounced among China's local small and medium-sized banks (SMBs), particularly urban and rural commercial banks. The bankruptcy of Baoshang Bank Limited serves as a stark reminder in this regard. To better address the potential crises of local SMBs and formulate targeted policy measures, it is essential to first clarify the underlying mechanisms.
Existing studies generally suggest that the external causes of the crises of local SMBs in China is that they have been forced to concentrate credit on long-cycle, low-return investment projects because of the fiscal pressure and debt expansion of the local government. The internal causes lie in governance issues, such as insider control and a lack of checks and balances among major shareholders. There are two debatable assumptions in existing literature: the local industrial structure is static, and the investments by local governments including state-owned enterprises (SOEs) are always economically inefficient. In reality, China's vertical industrial structure, differentiated by the capital intensity of local SOEs and private-owned enterprises (POEs), is in a dynamic adjustment process. Moreover, China's local governments have played a proactive role in promoting industrial upgrading through SOEs in capital-intensive sectors, which is a positive role that should be considered. However, this also implies that local governments need a specific financial institutional arrangement to allocate local credit resources: the proportion of credit available to SOEs versus POEs. Financial Decentralization (FD) has proven to be a feasible arrangement, which delineates and allocates control over financial resources between the government and the market entities (primarily POEs).
From the perspective of FD, the crisis of local SMBs results from an unreasonable arrangement of control over financial resources, which in turn induces credit misallocation across different industries. Local governments utilize the FD system to allocate credit from local SMBs, supporting SOEs in achieving industrial upgrading and increasing intermediate goods output. Subsequently, this process supports POEs in rapidly completing capital accumulation, thereby jointly driving local industrial advancement and economic growth. If both POEs and SOEs operate in industries where they hold comparative advantages, and the actual efficiency of POEs is relatively higher, FD helps improve credit allocation and reduces the potential for crisis in local SMBs. In this context, FD is directly reflected in the relative weight of control over local financial resource allocation between local governments and POEs. However, this capital investment-driven industrial upgrading is prone to imbalances. This includes SOEs over-upgrading into new industries or delaying exit from industries where they lack competitive advantages, thereby crowding out credit resources of POEs. Consequently, POEs become confined to the lower-output-level industries. In such cases, FD can easily lead credit to move towards less efficient sectors, which is credit misallocation across industries, breeding significant non-performing assets and increasing the potential crisis in local SMBs.
This paper may have two potential contributions. First, we introduce an industrial upgrading mechanism involving both SOEs and POEs into a bank run model, clarifying the theoretical mechanism through which the implicit institution of FD affects local SMB crises via credit misallocation. This macro-level perspective differs notably from the existing literature focusing on corporate governance and local government debt expansion. Second, while existing studies have empirically tested the impact of FD on the risks of urban commercial banks through channels such as financial competition and credit expansion, this paper further empirically examines the mechanism linking financial decentralization to local SMB crises through credit misallocation.
This study finds that FD determines the extent to which credit resources are allocated to private enterprises. When private firms are sufficiently efficient, FD helps alleviate credit misallocation, thereby reducing the probability of banking crises. Otherwise, its effect becomes insignificant. Local fiscal pressures partially offset the risk-mitigating role of FD. The findings of this study can help local governments adjust the control structure of financial resources according to their local conditions, thereby mitigating the risks of local SMBs while maintaining a dynamic balance between economic growth and local financial security.
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Received: 24 November 2024
Published: 24 April 2026
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