Shadow Banking and Its Risks

What Is Shadow Banking?

Shadow banking is defined as “Credit Intermediation carried out by non-banks”. In simple words, banks are responsible for carrying out all financial activities. However, certain other institutions perform bank-like activities but are not regulated by banks and are outside the boundaries of industry regulators. This is commonly referred to as Shadow Banking after PIMCO Economist Paul McCulley popularly coined the term in 2007. Examples of such institutions include Structured Investment Vehicles (SIVs), Payday Lenders, Asset Management Companies, Bond Trading Platforms, Investment Banks, and Conduits among others.

Common Ways Shadow Banking Works

  1. Maturity Transformation – investing in long-term assets by means of short-term funds
  2. Liquidity Transformation – buying illiquid assets through cash
  3. Leverage – buying fixed assets by borrowing capital
  4. Credit Risk Transfer – loan risk is transferred to another party

Countries with a High Percentage of Shadow Banking Activities

The statistics as per the sixth Annual Shadow Banking Report by the Financial Stability Board (FSB) (excluding shadow banking hubs – China and Luxembourg).

Shadow Banking Density

One of the main challenges when it comes to Shadow Banking is that their activities cannot be effectively regulated. This was one of the major factors that contributed to The Global Crises 2007 – 2009. Additionally, there are hardly any reliable statistics and it is difficult to ascertain the extent of shadow banking activities. Financial Stability continues to be one of the major Shadow Banking risks.

The Risks Associated With Shadow Banking

  1. Financial Instability
    As opposed to Commercial banks, these institutions often do not have insurance and therefore cannot borrow money from the Federal Reserve. Therefore, Shadow Banks remain vulnerable to shocks. Additionally, its interconnected nature can be a systematic cause of concern when one minor issue could escalate and shake the entire finance market.
  2. Hinders Effective Implementation Of Financial Policies
    An effectual monetary policy cannot be implemented due to the obscurity of the shadow banking operations, size, structure and interconnections. This leads to a lack of clarity that undermines the conduct of monetary policy. It further creates loopholes that come in the way of effectual tackling of issues, as they are immune to the direct control of the central bank.
  3. Uncertain Fluctuations, Fire Sales & Market Shocks
    Shadow Banks have the tendency to be Procyclical. Essentially, Procyclical in economics refers to an activity that is positively connected to the overall economy. This means that when the economy is in full boom, the shadow bank activates flourish. However, in the case of a downturn, their activities take a wrong turn of events. During the period of a flourishing economy, they have high leverage and can easily arrange for funds with the rise in asset price and the margin on secured lending remaining low. However, during the downturn period – asset price falls and margin on secured lending gets tighter making funding difficult and thereby underleverage themselves. Due to this procyclic tendency, their inter-linkage with banks becomes a problem that increases the risk of asset price bubbles, fire sales, market shocks; essentially an uncertain financial climate.

In conclusion, Shadow Banking is a problem when it creates a leverage like banks, but one whose activities are not under direct control and regulations. However, it is to be noted that Shadow Banks are a valuable alternative to bank funding as it helps diversify credit supply and significantly contributes to the overall economy. Therefore, this does not call for a complete abolishment of such practices but rather necessitates the strengthening of regulatory measures and timely updating of the monetary policies.

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