Shadow Banking

By Monica V

What is Shadow Banking? 

Paul McCulley of PIMCO coined the term “shadow bank” in 2007. The Financial Stability Board defines the shadow banking system as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”, servicing assets worth $80 trillion globally.

Components of the shadow banking system broadly include mobile payment systems, pawnshops, securitization vehicles, asset-backed commercial paper [ABCP] conduits, private equity funds, hedge funds, money market funds, markets for repurchase agreements, investment banks, and mortgage companies.

How they work? 

Shadow banks issue short-term securities and use the proceeds to buy longer-term assets. For instance, an ABCP conduit would issue commercial papers, which is bought by a money market fund, to raise funds, to purchase securitized products created by an investment bank.

What are their merits? 

* Ability to provide credit more cost-efficiently than traditional banks

* Provide funding to traditional banks

* Ensure credit growth and liquidity in the economy

* Alternative source of funding for risky borrowers

* Alternative to bank deposits for large investors

* Risk diversification

What is the risk? 

* Liabilities are liquid and assets are relatively illiquid

* Highly leveraged as their source of funding is not deposits but collateralized borrowing

* Involved in “chain of transactions”, which could lead to spillover of risk to the regulated banking sector, thus, leading to systemic risk

* Do not have safety nets, such as, Central Bank borrowing and Deposit Insurance, and no capital cushion, thus, raising concerns of run on the banks.

Conclusion: 

Shadow banks have been held responsible for the global financial crisis and the Chinese Slowdown. The Dodd Frank Act, passed by the U.S. Congress, has introduced many regulations such as moving OTC derivatives to exchanges, and registration requirements for some hedge funds. There is a need to propose regulations such that spillover effect between the banking sectors is mitigated, susceptibility of money market funds to runs is reduced, incentives associated with securitization are aligned, pro-cyclicality associated with securities financing transactions is dampened.

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