Aspects of Shadow Banking System
Definition
-- Shadow banks are entities which are in the lending business; but they are not banks
-- banks are tightly regulated, but shadow banks are not subject to the same regulation as banks are subjected to
-- as they are not tightly regulated, there is a regulatory arbitrage for shadow banks
-- the term ‘shadow bank’ was coined by economist Paul McCully in a 2007 speech at Jackson Hole, Wyoming, USA
-- shadow banking system is defined by FSB as ‘credit intermediation involving entities and activities outside the regular banking system’
-- the Financial Stability Board (FSB) is an international body that monitors and makes recommendations about the global financial system – it’s based in Basel, Switzerland
-- shadow banks are outside the banking regulation system performing the core banking function of credit intermediation (that is, taking money from savers and lending it to borrowers)
-- some financial market participants prefer to use the term ‘market-based finance’ instead of shadow banking
-- shadow banks play a key role in supplying credit and providing liquidity to the economy
-- non-bank financing is a critical alternative to bank funding and supports real economic activity
-- if the funding of shadow banks is based on short-term, shadow banks (similar to banks) can be vulnerable to “runs” during a crisis leading to a contagion risk
-- shadow banks do not have access to central bank liquidity or public sector credit guarantees
-- shadow banks do not have transparency on their assets and liabilities and as such they are called shadow banks
-- during the 2008 Global Financial Crisis (GFC), shadow banking system became a source of systemic risk, especially in the US and Europe
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Related Blogs:
What is Shadow Banking?
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Shadow Banks in India
-- in the Indian context: shadow banks are NBFCs or non-banking financial companies, insurance funds and mutual funds; but in recent years, NBFC regulation is tightened by Reserve Bank of India (RBI), removing some portion of the regulatory arbitrage enjoyed by NBFCs
-- strictly speaking, NBFCs in India cannot be termed as shadow banks in the sense of non-regulation because they have been in the regulatory ambit of Reserve Bank of India (RBI) since the mid-1960s
-- compared to the US, the Indian shadow banking system is smaller and less complex
-- there is inter-connectedness between banks and money market mutual funds (MMMFs)
-- in India, banks, NBFCs, mutual funds and insurance companies are inter-connected with a network effect of interaction
Shadow Banks in the US
-- in the US context: shadow banks are money market mutual funds, investment banks, structured finance vehicles, broker-dealers, non-bank finance companies, hedge funds, real estate funds, pension funds, and asset managers
-- some of the activities of US shadow banks include: money market mutual funds (MMMFs), structured finance, subprime residential mortgage-backed securities (RMBS), asset-backed securitisation (ABS), asset-backed commercial paper (ABCP) programmes, structured investment vehicles (SIVs), collateralised debt obligations (CDOs)
-- in the US, shadow banks don’t take deposits from the public, as such they are not as highly regulated as banks
-- After the 2008 GFC, shadow banking system is under greater scrutiny
-- in the US, shadow banks were brought into regulation in 2010 as per the Dodd Frank Act
-- because of regulatory arbitrage, shadow banks take higher risks; these higher risks may turn out to be systemic risk as happened during the 2008 GFC
-- in the US, the collective investment vehicles (like, money market mutual funds, fixed income funds, credit hedge funds and real estate funds) have grown fast and they now form a bigger part of the US shadow banking system
-- the role of ABCP, RMBS, SIVs and CDOs in the US shadow banking system has come down after the 2008 GFC
-- in the US, shadow banks earn higher returns from private credit
-- because of tighter regulations, banks in the US don’t participate in leveraged buyouts – creating opportunities for private equity firms, like, Carlyle
-- due to problems being faced by regional banks in the US, regional banks appetite for providing business loans may suffer – and this provides the opportunity for big investment firms, like, Blackstone, Apollo Global Management and Ares Management to fill the gap and provide loans to large, medium and small businesses
-- in the US, private credit business has grown very fast since the 2000s
-- financial markets are inter-connected globally; so are banks and shadow banks
-- shadow banks have close interlinkages with the banking sector on the assets and liabilities side
-- the growth of shadow banking industry in the US may pose systemic risk and financial stability risk once again in future
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RBI speech 17Jun2014 on Role of NBFCs in Financial Sector
FSB Global Monitoring Report on Non-Bank Financial Intermediation 20Dec2022
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Disclosure: I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets.
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He blogs at:
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