The shadow banking system describes financial intermediaries that participate in creating credit but are not subject to regulatory oversight.
Understanding Shadow Banking Systems
Banks play a pivotal role in the economy by taking money from depositors and creating new credit to make loans. They usually operate under strict scrutiny from financial regulators. However, shadow banks, often known as nonbank financial companies (NBFCs), can operate with little to no oversight from regulators.
Examples of shadow banks or financial intermediaries not subject to regulation include hedge funds, private equity funds, mortgage lenders, and even large investment banks. The term can also refer to unregulated activities by regulated institutions, which include financial instruments like credit default swaps.
Key Takeaways
- The shadow banking system consists of lenders, brokers, and other credit intermediaries outside traditional regulated banking.
- Shadow banking is generally unregulated and not subject to the same risks, liquidity, and capital restrictions as traditional banks.
- The shadow banking system played a major role in the expansion of housing credit leading up to the 2008 financial crisis.
- Despite government oversight efforts since 2008, shadow banking has grown in size, posing potential risks to the global financial system.
History and Evolution of Shadow Banking
The shadow banking sector consists mainly of NBFCs, which emerged as innovators in financial markets. Economist Paul McCulley coined the term “shadow banks” in 2007 to describe institutions involved in the easy-money lending atmosphere which contributed to the subprime mortgage crisis and the 2008 financial meltdown.
Strict regulatory scrutiny on traditional banks post-crisis led to a contraction in their lending activities. Consequently, stricter loan requirements steered individuals and businesses towards nonbank “shadow” institutions, which operated beyond banking regulations.
The shadow banking system has largely escaped regulation as they do not hold traditional demand deposits, such as checking or savings accounts, keeping them outside conventional federal and state financial oversight. Rather, they engage in credit intermediation activities like maturity transformation, liquidity transformation, credit risk transfer, and leverage.
Notable Statistics and Global Impact
The shadow banking system, dramatically expanding post-2007 financial crisis, was only subjected to scrutiny after significant growth caught regulators’ attention. By 2021, shadow banking constituted 49.2% of total global financial assets, as reported by the Financial Stability Board.
Countries with prominent shadow banking sectors include the United States and China. In 2019, China reported shadow banking assets worth $12.9 trillion, making up 86% of its GDP.
Shadow Banking Risks and Regulations
The shadow banking industry meets rising U.S. credit demands. However, its disintermediation leads to concerns over potential systemic risks. Unlike traditional bank deposits insured by the Federal Deposit Insurance Corporation (FDIC), assets held by NBFCs lack similar protection, nor can these entities access emergency Federal Reserve loans.
Regulatory efforts like the Dodd-Frank Act imposed greater liability on the banking industry but left the shadow banking sector largely unscathed. Regulatory bodies now aim to control the risk posed by shadow banking by limiting traditional banks’ exposure to unregulated entities and products. Outside the U.S., countries like China have initiated efforts to curb risky financial practices within the shadow sector.
Common Examples of Shadow Banks
Notable shadow banking entities include:
- Investment banks like Goldman Sachs and Morgan Stanley
- Mortgage lenders
- Money market funds
- Insurance and re-insurance companies
The Benefits of Shadow Banking
Proponents argue that shadow banking reduces dependency on traditional banks for credit. This adds diversification to the financial system, provides additional lending sources, and aids the economy.
Should Shadow Banks Be Regulated?
Regulatory bodies, including the European Commission, believe that shadow banks should be regulated. They cite potential systemic risks, close ties to regulated financial sectors, and regulatory arbitrage, where entities exploit loopholes to bypass regulations as significant concerns.
Conclusion
The shadow banking system encompasses lenders, brokers, and other credit intermediaries operating outside traditional regulated banking sectors. While shadow banking sounds ominous, many reputable brokers and investment firms partake in these activities. Advocates note that shadow banks provide crucial credit unavailable through traditional banking means. However, opponents caution that the unregulated nature of shadow banking poses risks to both consumers and the broader financial system.
Related Terms: Hedge Funds, Private Equity, Credit Default Swaps, Investment Banks, Financial Crisis.
References
- International Monetary Fund. “Shadow Banks: Out of the Eyes of Regulators.”
- Center for American Progress. “Strengthening the Regulation and Oversight of Shadow Banks.”
- International Monetary Fund. “What Is Shadow Banking?”
- Financial Stability Board. “A Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities and a Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos”, Page 2.
- WorldBank. “Nonbank Financial Institution.”
- Financial Stability Board. “Global Monitoring Report on Non-Bank Financial Intermediation 2022”.
- The Helen Brown Group. “Shadow Banks”.
- South China Post. “China Estimates Shadow Banking Worth US$12.9 Trillion as It Moves to Clean up High-Risk Sector”.
- U.S.-China Economic and Security Review Commission. “Section 2: Vulnerabilities in China’s Financial System and Risks for the United States”, Page 243.
- European Commission. “Financial Supervision of Shadow Banking”.
