Hu Xiaolian, deputy governor of the People's Bank of China, the central bank, alerted banking regulators on Thursday to hidden risks in China's financial sector even though the assets and profits of domestic banks have rapidly grown.

"If the banks provide a number of dazzling products that most people don't understand and that create demand only within the financial system, but the products become a major source of profit for banks, we should pay high attention to the hidden financial risks and their impact on the economy," Hu said at the 18th International Conference of Banking Supervisors in Tianjin.

Hu Xiaolian, deputy governor of the People's Bank of China

She said the regulator should evaluate banks on a number of factors, including the development of banking businesses, risk control, level of profitability and social contributions.

"When we are judging whether or not the banking sector is healthy and whether it can develop sustainably, we should assess whether its development matches the growth of the real economy besides such evaluation indexes as capital adequacy, asset quality and return on equity," she said.

The rapid growth of shadow banking in China is largely driven by arbitrage. On the one hand, shadow banking businesses are not standardized. On the other hand, they satisfy multi-tier demands for financing in the context of diversified economic development.

"We should analyze shadow banking from various aspects and then decide which kind of regulation is the most suitable and the most needed, rather than completely deny its positive effects simply because of arbitrage," Hu said.

The regulators must first analyze whether a specific shadow banking business has close ties with the real economy or if it is just a transfer of business among financial institutions.

They then have to make an accurate judgment of the actual financial risks it may cause. Later, they need to assess how the increase in operating costs for banks caused by inconsistent regulatory standards will affect the financial system and the real economy.

Hu advised regulators to make rules that will guide shadow banking businesses to serve domestic companies' demands for funding while strengthening standardized management of such businesses.

Jaime Gonzalez, president of the National Banking and Securities Commission of Mexico, said Hu made some good points.

"We have to understand our problems first instead of just trying to regulate and say that shadow banking is wrong without really understanding the problem," Gonzalez said on the sidelines of the conference.

From his perspective, shadow banking has to be regulated because it would be unfair for the other competitors in the sector not to have this kind of activity be regulated by the corresponding authority. But the supervisor should not limit innovation or the demand for funds because of limited resources, he said.

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