A new document outlining tighter controls over shadow banking activity reportedly has been circulating with China's financial regulators, but Sun Mingchun, chief economist and founding partner at equity-hedge fund China Broad Capital, said that while more regulation is necessary, shadow banking is filling a financial gap that traditional institutions cannot.

"Shadow banking: this is a topic that kept investors awake over the past few years - China investors. Actually, last night, I was kept awake by the Asia market, which dropped by 1.8 percent," said Sun. In two days' time, the Asian index dropped 4 percentage points, which Sun attributed to rumors of new shadow-banking regulation.

Shadowing banking activity has led to several credit crunches during 2013, causing the central bank to inject liquidity into the financial system and raising interbank lending rates to record highs.

The China Securities Journal reported this week that the central government had circulated a new document detailing shadow banking and how it intends to regulate activity that has been conducted by these non-traditional financial institutions.

An official from the People's Bank of China, the country's central bank, told China Daily that he could not confirm the existence of the document. The China Banking Regulatory Commission said that while it hasn't received the document yet, it has "noticed related media reports."

In the document, according to the newspaper, regulators listed three categories of shadow banking entities: the first are unlicensed financial intermediaries, the second are licensed but not sufficiently regulated, and the third are licensed financial entities that have parts of their businesses insufficiently regulated.

Sun - who made his remarks on Monday at a 2014 economic forecast event hosted by the National Committee of US-China Relations held at the New York Stock Exchange - said he's not worried about the immediate future of shadow banking, which he believes is necessary for the Chinese economy. Shadow banks are placating a financing gap that Sun said is growing larger and larger.

"You look at China's fixed-asset investment, versus annual new loan growth in the past eleven years. The amount of investment increased by 11 times, the amount of loans increased by four to five times," he said. This gap, he said, is caused by the financing needs of the economy and the restraints of how much the formal banking system and corporate sector can provide.

Excessive regulation is also leading to quickening demand of shadow banks' resources, Sun said. The IPO market is still shut down, the bond market in China is small, and there are no municipal bonds yet - "Developers cannot use equity market for financing for many years," he said.

China needs to invest upwards of $11.6 trillion (70 trillion yuan) each year, Sun remarked, but the country's GDP totaled $8.6 trillion (51.9 trillion yuan) in 2012, making it hard to bridge that gap without relying on shadow banks.

That isn't to say that the system is without its problems, like the double-digit interest rates for loans, which Sun said is "concerning," because "not many projects can have high returns" enough to make up for the high interest rate. Sun also recommended that system be more institutionalized and be made "more transparent," though he did not specify how.

But without shadow banking, China could have hit a sudden drop-off in growth much faster, he said. "I have to say, over the past few years, without the financing provided by the shadow banking system, we could have already had a hard-landing in China," Sun said. "We won't be able to get 7.5 or 8 percent GDP growth in the past two, three years."

Sun predicted that default is coming in the near future, but views that as a good thing and remains optimistic about the shadow-banking system's prospects. "We need to have some default to normalize the credit spread. We don't really have a good spread in China today," he said. "But on the other hand, I don't think systematic implosion is likely in the next one or two years."

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