What Is the Shadow Banking System?
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What Is the Shadow Banking System?

5 Min.

Shadow banking refers to a parallel financial system that operates outside the traditional regulated banking sector. It includes various lenders, brokers, and credit intermediaries. Unlike traditional banks, shadow banking is not subject to the same regulations regarding risk, liquidity, and capital requirements. It played a significant role in the housing credit expansion before the 2008 financial crisis. Since then, the shadow banking system has continued to grow and evade government oversight, posing potential risks to the global financial system.

Basics

The shadow banking system refers to unregulated financial intermediaries that contribute to credit creation. Unlike traditional banks, these entities operate with little to no regulatory oversight. Examples of shadow banks include hedge funds, private equity funds, mortgage lenders, and large investment banks. Additionally, the term can encompass unregulated activities conducted by regulated institutions, such as the use of financial instruments like credit default swaps. The shadow banking system plays a significant role in the economy by participating in credit creation outside the bounds of regulatory scrutiny.

Meaning of Shadow Banking Systems

Shadow banking primarily consists of Non-Bank Financial Companies (NBFCs) regulated under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The term "shadow banks" was coined by economist Paul McCulley in 2007 to describe the expanding network of institutions involved in easy-money lending, which contributed to the subprime mortgage crisis and the subsequent 2008 financial meltdown.

Well-known brokerage and investment firms, including Lehman Brothers and Bear Stearns, were prominent NBFCs at the center of the 2008 financial crisis. After the crisis, traditional banks faced stricter regulatory scrutiny, resulting in reduced lending. This led to an increased demand for alternative funding sources, giving rise to nonbank "shadow" institutions that operated outside conventional banking regulations.

The shadow banking system has evaded regulation primarily because these institutions are not permitted to accept traditional demand deposits from the public. This exemption keeps them outside the oversight of federal and state financial regulators.

Instead of accepting deposits, shadow banks engage in various financial transactions. The Financial Stability Board (FSB), an international body of financial authorities, defines shadow banking based on different activities performed by institutions operating outside the regulatory framework. These activities include transforming short-term funds into long-term investments, converting cash or assets into less liquid investments, transferring credit risk to another party, and leveraging borrowed funds to enhance returns.

A Brief History of the Shadow Banking System

Shadow banking institutions emerged as alternative players in financial markets, offering financing for various purposes without facing the same regulatory oversight as traditional lenders. They were able to create riskier financial instruments and operate without the capital requirements imposed on banks.

Following the 2007-08 financial crisis, the shadow banking sector expanded significantly, addressing the unmet credit demand. Despite increased scrutiny from regulators, the sector continued to grow. According to the Financial Stability Board, the shadow banking system, known as the nonbank financial intermediary sector, experienced substantial growth, driven by investment funds and reaching a significant share of global financial assets.

It is not surprising that the two largest economies, the U.S. and China, have significant concentrations of shadow banking assets. The United States holds the highest amount of shadow banking assets, while China follows closely behind. In 2019, Chinese financial regulators reported that shadow banking accounted for approximately $12.9 trillion in assets, equivalent to 86% of the country's GDP or 29% of its total banking assets.

Risks and Regulations Associated With Shadow Banking

The shadow banking industry in the United States meets the increasing demand for credit. However, its unregulated nature raises concerns about systemic risks to the financial system. Unlike bank deposits protected by the FDIC, assets held by NBFCs in shadow banking lack similar protection. These entities also cannot access emergency loans from the Federal Reserve, unlike banks.

While the Dodd-Frank Act of 2010 focused on banking industry reforms, the shadow banking sector remained largely unregulated. Although some liability was imposed on selling exotic financial products, most non-banking activities remained unregulated.

Regulators aim to reduce risks by examining the exposure of traditional banks to unregulated entities and products. This can help limit the overall economic risk posed by shadow banking, although non-bank financial companies themselves are not directly regulated.

To address the issue, the Federal Reserve Board proposed applying similar margin requirements to nonbanks, such as broker-dealers. Outside the United States, China implemented directives in 2016 to target risky financial practices like excessive borrowing and speculation in equities.

Should Shadow Banks Be Regulated at All?

The European Commission and other institutions advocate for the regulation of the shadow banking sector. They emphasize the need for regulation due to its significant size, close ties to the regulated financial sector, and the systemic risks it presents. Additionally, there is a concern about preventing the misuse of the shadow banking system for regulatory arbitrage, which involves exploiting loopholes to evade regulatory restrictions.

Some Benefits of Shadow Banking

Supporters of shadow banking highlight its advantage of reducing reliance on traditional banks for credit. This is beneficial for the economy as it offers an additional lending source and brings diversification to the financial system.

Known Shadow Banks Examples

Here is a list of well-known shadow banking entities:

  1. Money market funds
  2. Insurance/reinsurance companies
  3. Mortgage lenders
  4. Investment banks (e.g., Goldman Sachs, Morgan Stanley)

Conclusion

Shadow banking refers to the activities of lenders, brokers, and credit intermediaries outside traditional regulated banking. Some well-known financial firms are involved in shadow banking. Proponents argue that it provides necessary credit not available through traditional banks, while critics raise concerns about its unregulated nature and potential risks to consumers and the overall financial system.

 

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