What Is Shadow Banking? Definition and Meaning

Shadow banking refers to non-financial institutions that provide banking and financial services but operate outside the regulatory environment of the conventional banking system. The industry is expanding despite reservations from regulators. It offers several types of facilities such as offering credit, securitization, and money market derivatives.

What is shadow banking?

The Financial Stability Board (FSB) defines shadow banking as: “Credit intermediation involving entities and activities (fully or partly) outside of the regular banking system”. Broadly speaking, it refers to financial institutions and markets that offer similar services to commercial banks (and other financial institutions) but are outside the regulatory circle of the conventional financial system.

Financial institutions working under the shadow banking system often work as intermediaries between consumers and conventional financial institutions. The term may also refer to the unregulated activities of conventional banks sometimes. However, generally, the term is associated with the financial intermediaries working outside the conventional regulatory boundaries.

The activities of the shadow banking industry 

These institutions offer credit and capital facilities to companies, institutional investors, and corporations. Shadow banking institutions include:

  • Mortgage lending companies
  • Hedge Funds
  • Repurchase Agreements (Repos)
  • Asset-backed commercial papers
  • Structured Investment Vehicles (SIVs)
  • Money Market Funds
  • Payday Lenders

These entities do not receive deposits from retail customers, although they offer some services to them such as P2P lending facilities. The fact these institutions do not accept direct deposits from retail customers lets them stay outside the bounding regulations that apply to conventional banks and financial institutions.

It means these entities operate with higher credit, liquidity, and market risks. 

How large is the industry?

In many countries, the unregulated activities of some conventional institutions and most of the shadow banking institutions are often undocumented. Thus, the true extent and breadth of the industry are hard to evaluate.

A research report by the FSB indicated the size of the shadow banking system in the EU region reached $ 45 trillion as of 2016. The US remains the largest contributor to the shadow banking system with estimated assets of $52 trillion held by these entities.

One of the largest shadow banking markets exists in China. However, reliable data had been unavailable since the authorities only defined the term publicly in 2017. A report suggests the size of the shadow banking system at $ 13 trillion as of 2017 in China.

Shadow banking and the regulators

It has largely remained out of the jurisdictions of regulators in most countries. Since these institutions do not receive deposits directly from retail customers, they remain unscathed by regulations that conventional banking systems face. The systematic risks of credit, liquidity, and market risks are still large enough to affect the linked entities as well. In fact, many of these institutions are held by the parent companies in the conventional financial sector.

Regulatory authorities around the world have started scrutinizing shadow banking entities rigorously. For instance, due to increased measures undertaken by Chinese officials, the size of the shadow banking industry shrank in China. However, in many global jurisdictions, the conventional financial regulations do not apply to the industry as of yet.

Advantages

Despite posing several risks to the financial industry, the shadow banking industry offers some discrete advantages. It provides credit facilities to borrowers that cannot often access conventional lenders. A prime example of that is a growing trend in the private equity and P2P lending sectors.

Risky ventures such as startups would be unable to obtain capital if not for these institutions. Similarly, retail borrowers can have access to credit facilities through private lending platforms, only possible due to these non-financial institutions. The shadow financial system also offers liquidity through its repackaging of various types of debt instruments. These activities involve the securitization of asset-backed mortgages (ABMs), structured investment vehicles (SIVs), and credit default swaps (CDS).

Risks 

Due to the highly unregulated environment and risky nature of business, the shadow banking industry poses some risks to the economy and the connected conventional financial industry.

Increased systemic risk

As seen during the global recession 2008, the unregulated activities of these institutions that pursue higher market, credit, and liquidity risks can lead to a systemic failure.

Investor safety

Funds held by non-financial institutions are non-insured by the Federal Deposit Insurance Corporation (FDIC) and other insurers. Therefore, the system can pose risks for investors if anything goes wrong with these entities.

Liquidity risk

These institutions do not receive public funds directly. Also, they are not counterparties to their respective central banks as well. Thus, these entities face higher liquidity risks than conventional banking institutions.

Risks to conventional banking system

Many of the non-financial entities are owned by conventional banks and corporations. Many of them have invested heavily in these non-financial entities as well. A downfall of the shadow banking system may quickly lead to an economic recession, and risks to the conventional financial system as well.

Image source: CNBC

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