L Introduction We examine the role of China's financial system in supporting the growth of its economy and explore the directions of its future development. Almost every functioning financial system includes financial markets and intermediaries(e.g, a banking sector), but how these two sectors contribute to the entire financial system and economy differs significantly across different countries Although there is no consensus regarding the prospects of China's future economic growth, a prevailing view on China's financial system speculates that it is one of the weakest links in the economy and it will hamper future economic growth A comprehensive examination of all aspects of China's financial system, and extensive comparisons with other countries where data is available are provided below. We also discuss wha has worked and what remains to be done within the financial system, and examine how further development can better serve the entire economy. Finally, we provide guidelines for future research and policy making on several important unresolved issues, including how China's financial system should integrate into the world's markets and economy We draw four main conclusions about China's financial system and its future development First, when we examine and compare China's banking system and financial markets with those of both developed and emerging countries, we find China's financial system is dominated by a large but under-developed banking system, which is mainly controlled by the four largest state-owned banks with a large amount of non-performing loans (NPLs). The continuing effort of improving the banking system, in particular, reducing the amount of NPLs of the major banks to normal levels, is the most important aspect of reforming Chinas financial system in the short run We consider three channels through which the NPls can be reduced and efficiency of the banking sector improved. The main obstacle in evaluating these solutions is the lack of accurate bank-level data. First, the entrance and growth of non-state banks and intermediaries should be encouraged. With more domestic and foreign banks and intermediaries, the banking sector becomes more competitive, and competition improves the incentives and efficiency of state-owned banks Second, the ongoing privatization of state-owned banks will not be completed until the majority of these banks' assets are owned by non-government organizations and investors. With(majority) state ownership, banks will have perverse incentives in selecting borrowers and borrowers(in particular, state-owned companies) have perverse incentives in selecting investment projects. As a result, a large amount of new NPLs may surface within the network of state-owned banks as the government rids old NPLs from the banks' books. Third. the Chinese government and central bank2 I. Introduction We examine the role of China’s financial system in supporting the growth of its economy and explore the directions of its future development. Almost every functioning financial system includes financial markets and intermediaries (e.g., a banking sector), but how these two sectors contribute to the entire financial system and economy differs significantly across different countries. Although there is no consensus regarding the prospects of China’s future economic growth, a prevailing view on China’s financial system speculates that it is one of the weakest links in the economy and it will hamper future economic growth. A comprehensive examination of all aspects of China’s financial system, and extensive comparisons with other countries where data is available are provided below. We also discuss what has worked and what remains to be done within the financial system, and examine how further development can better serve the entire economy. Finally, we provide guidelines for future research and policy making on several important unresolved issues, including how China’s financial system should integrate into the world’s markets and economy. We draw four main conclusions about China’s financial system and its future development. First, when we examine and compare China’s banking system and financial markets with those of both developed and emerging countries, we find China’s financial system is dominated by a large but under-developed banking system, which is mainly controlled by the four largest state-owned banks with a large amount of non-performing loans (NPLs). The continuing effort of improving the banking system, in particular, reducing the amount of NPLs of the major banks to normal levels, is the most important aspect of reforming China’s financial system in the short run. We consider three channels through which the NPLs can be reduced and efficiency of the banking sector improved. The main obstacle in evaluating these solutions is the lack of accurate bank-level data. First, the entrance and growth of non-state banks and intermediaries should be encouraged. With more domestic and foreign banks and intermediaries, the banking sector becomes more competitive, and competition improves the incentives and efficiency of state-owned banks. Second, the ongoing privatization of state-owned banks will not be completed until the majority of these banks’ assets are owned by non-government organizations and investors. With (majority) state ownership, banks will have perverse incentives in selecting borrowers and borrowers (in particular, state-owned companies) have perverse incentives in selecting investment projects. As a result, a large amount of new NPLs may surface within the network of state-owned banks as the government rids old NPLs from the banks’ books. Third, the Chinese government and central bank