Proximity Matters: How External Auditing Impacts Shadow Banking Activities of Chinese Commercial Banks

We explore whether and how external auditing influences bank clients’ shadow banking activities by focusing on the impact of auditor–client geographic proximity. Using data from Chinese banks between 2000 to 2020, our findings indicate that the shadow banking activities of commercial banks decrease as auditor–client distance decreases, supporting the professional competence‐enhancement effect. Mechanism analyses indicate that nearby auditors have a higher perception of risk and thus charge more audit fees and disclose more key audit matters and suppress shadow banking activities more for bank clients with higher risk. Analyses of heterogeneity show that the reduction effect is more pronounced for auditors with lower capabilities, banks facing higher competition, and banks located further from regulators. The path analysis demonstrates that geographic proximity between auditors and bank clients can reduce systemic risk by decreasing shadow banking activities. Finally, we provide further evidence that the reduction in on‐balance‐sheet shadow banking driven by nearby auditors leads to a partial shift toward off‐balance‐sheet shadow banking activities. These findings offer valuable insights for regulators seeking to control shadow banking systems and reduce systemic risks.