What’s it: Shadow banking is intermediary financial activities but is not subject to the banking system’s regulatory oversight. They usually take other parts of the financial system, which commercial banks are neither allowed nor willing to take.
Shadow banking includes many financial institutions. Examples are hedge funds, investment banks, private equity funds, money market funds, special purpose entity conduits (SPE), and structured investment vehicles (SIVs). We collectively call shadow banks.
The presence of shadow banking enlarged the scale of the financial crisis in 2008-2009. Shadow banking credit contributed to the sharp rise in asset prices on the real estate market before the financial crisis. The asset bubble then burst and created a crisis.
During this period, the investor becomes restless and withdraws funds altogether from the system. To pay for it, shadow banks must sell their assets. That, in turn, spurred a deeper economic downturn.
Before the crisis, shadow banks saw their assets hit $62 trillion in 2017 and shrink to $59 trillion during the crisis. And by the end of 2015, assets had shot up again to $92 trillion.
How shadow banking works
Shadow banks function much like traditional banking. They raise money and invest it in various assets, including injecting capital into various companies.
However, shadow banks are not regulated in the same way as commercial bank loans. They are not subject to most of the regulatory restrictions of the banking system.
Sources of funding
Unlike commercial banks, shadow banks don’t take public deposits as a source of funding. They also do not have access to central bank funding, interbank loans, or public sector credit guarantees.
Instead, shadow banks rely on alternative short-term funding. They operate in the repo market, commercial paper, or issue asset-backed securities. For example, borrowers offer collateral for cash loans in the repo market by selling securities to shadow banks. The borrower agrees to buy back the collateral in the future at an agreed price.
Other sources of funding come from institutional investors and accredited investors. They are willing to provide significant funding.
Shadow banks target markets beyond the reach of traditional banks. For example, private equity funds often target startup companies. They usually do not have access to banks or capital markets because of their high risk. On the other hand, commercial banking is also prohibited and unwilling to do so due to regulatory considerations.
Several other shadow banks operate through a variety of securitization techniques such as:
- Asset-backed securities (ABS)
- Collateralized debt obligations (CDOs)
- Asset-backed commercial paper (CP)
- Repurchase agreements (repos).
They do this through a chain of non-bank financial intermediaries and take several complex and multi-step processes. Certain types of shadow banks handle each step and through certain funding techniques.
- Raising short term funds and investing them in long term assets.
- Using liquid liabilities to buy risky and long-term assets.
- Taking advantage of leverage to increase the potential profit (or loss) from an investment.
- Transferring the borrower’s default risk to another party.
As compensation, shadow banks take income from fees or profit from interest rate arbitrations. Their profit also comes from the sale of an entity’s shareholdings, as private equity funds do.
Shadow banking pros and cons
Shadow banks have played an increasingly significant role in facilitating credit in the financial system. They provide credit and liquidity outside the banking system. Thus, they exist as an alternative loan source and provide diversification in the financial system. For this reason, they contribute to promoting broader economic growth.
Meanwhile, the opposing sides of shadow banking are:
- Amplifying risk in the financial system. Shadow banks operate like banks but with minimal supervision. They increase systemic risk because they have links with the traditional banking system through the credit intermediation chain. If a problem occurs in the shadow banking system, the risk can quickly spread to the traditional banking system.
- Loosely regulated. Monitoring shadow banking activities is often difficult because of the lack of information disclosure. For this reason, in some countries, regulators are starting to introduce regulations. For example, through the Dodd-Frank Act, the United States Federal Reserve has the power to regulate shadow banks with systemic impacts. One example of regulation is the registration requirements for hedge funds with more than $150 million assets.
- Having no deposit insurance. Unlike commercial banks, funds from capital suppliers do not have credit guarantees. If the confidence of the suppliers of capital falls, they can withdraw their funds at once. It disrupted shadow bank operations and forced them to sell assets. And, in the end, the shocks spread and destroy the financial system.
- High liquidity risk. Shadow banks raise short-term funds and use them to invest in long-term assets. As a result, during periods of illiquid markets, they can go bankrupt and fail to meet their short-term obligations.