What is shadow banking?
The shadow banking system is a term for the collection of non-bank
financial intermediaries that provide services similar to traditional
commercial banks
How are Shadow Banks Dissimilar to Banks?
Shadow banks, like conventional banks undertake various
intermediation activities akin to banks, but they are fundamentally distinct
from commercial banks in various respects. First, unlike commercial banks,
which by dint of being depository institutions can create money, shadow
banks cannot create money. Second, unlike the banks, which are
comprehensively and tightly regulated, the regulation of shadow banks is not
that extensive and their business operations lack transparency. Third, while
commercial banks, by and large, derive funds through mobilization of public
deposits, shadow banks raise funds, by and large, through market-based
instruments such as commercial paper, debentures, or other structured credit
instruments. Fourth, the liabilities of the shadow banks are not insured, while
commercial banks deposits, in general, en!oy "overnment guarantee to a
limited extent. Fifth, in the times of distress, unlike banks, which have direct
access to central bank li#uidity, shadow banks do not have such recourse.
$hile there may be stark differences in the way the shadow banks
operate as compared to banks, sometimes there is only a thin line separating
the two. For instance a regulated bank may float a Special %urpose &ehicle
'S%&( to hold some specific assets, with a view at removing them from its
balance sheet.
Shadow banks) role in the financial system and their modus operandi
*ike regular banks, shadow banks provide credit and generally increase
the li#uidity of the financial sector. +et unlike their more regulated
competitors, they lack access to central bank funding or safety nets such
as deposit insurance and debt guarantees. ,n contrast to traditional banks,
shadow banks do not take deposits. ,nstead, they rely on short-term funding
provided either by asset-backed commercial paper or by the repo market, in
which borrowers in substance offer collateral as security against a cash loan,
through the mechanism of selling the security to a lender and agreeing to
repurchase it at an agreed time in the future for an agreed price. -oney
market funds do not rely on short-term funding. rather, they are investment
pools that provide short-term funding by investing in short-term debt
instruments issued by banks, corporations, state and local governments, and
other borrowers. The shadow banking sector operates across the /merican,
0uropean, and 1hinese financial sectors, and in perceived tax
havens worldwide. Shadow banks can be involved in the provision of long-
term loans like mortgages, facilitating credit across the financial system by
matching investors and borrowers individually or by becoming part of a chain
involving numerous entities, some of which may be mainstream banks. 2ue
in part to their specialized structure, shadow banks can sometimes provide
credit more cost-efficiently than traditional banks. / headline study by
the ,nternational -onetary Fund defines the two key functions of the shadow
banking system assecuritization 3 to create safe assets,
and collateral intermediation 3 to help reduce counterparty risks and facilitate
secured transactions. ,n the 4S, prior to the 5667 financial crisis, the shadow
banking system had overtaken the regular banking system in supplying loans
to various types of borrower. including businesses, home and car buyers,
students and credit users.
/s they are often less risk averse than regular
banks, entities from the shadow banking system will sometimes provide loans
to borrowers who might otherwise be refused credit. -oney market funds are
considered more risk averse than regular banks and thus lack this risk
characteristic.
The risks associated with shadow banking
/s shadow banks do not take deposits, they are sub!ect to less
regulation than traditional banks. They can therefore increase the rewards
they get from investments by leveraging up much more than their mainstream
counterparts and this can lead to risks mounting in the financial system.
4nregulated shadow institutions can be used to circumvent the strictly
regulated mainstream banking system and therefore avoid rules designed to
prevent financial crises. -oney market funds are highly regulated under
the ,nvestment 1ompany /ct of 89:6, which imposes stricter regulation than
banking regulation.
Shadow banks can also cause a buildup of systemic risk indirectly
because they are interrelated with the traditional banking system via credit
intermediation chains, meaning that problems in this unregulated system can
easily spread to the traditional banking system. /s shadow banks use a lot of
short-term deposit-like funding but do not have deposit insurance like
mainstream banks, a loss of confidence can lead to ;runs; on these
unregulated institutions. Shadow banks) collateralised funding is also
considered a risk because it can lead to high levels of financial leverage. eserve to regulate all
institutions of systemic importance. ,n order to put a control on the
burgeoning shadow banking activities, the 0uropean 4nion has also put in
place some measures, which inter alia include prudential rules concerning
securitisation, regulation of credit rating agencies, etc. Further, at the re#uest
of "-56 countries, at international level, FS< has been working towards
strengthening the oversight and regulation of the shadow banking system so
that the risks emanating from them may be mitigated. &arious other countries,
including ,ndia are working towards improving the regulatory framework so as
to curb the shadow banking activities, which pose a risk to financial stability.
Challenges Posed B Shadow Banks
Though the focus of regulation on shadow banking activities emerged in
the wake of their alleged role in the recent global crisis, shadow banking
system is not a new development. 0ven in the late 89?6s and early 89@6s,
concerns emanating from the growth of non-bank financial intermediaries had
been highlighted AThorn '89?B(. Cogan '89@6(D. Thorn '89?B( had advocated
same degree of control over credit expansion by the E
The shadow banking system is a term for the collection of non-bank
financial intermediaries that provide services similar to traditional
commercial banks
How are Shadow Banks Dissimilar to Banks?
Shadow banks, like conventional banks undertake various
intermediation activities akin to banks, but they are fundamentally distinct
from commercial banks in various respects. First, unlike commercial banks,
which by dint of being depository institutions can create money, shadow
banks cannot create money. Second, unlike the banks, which are
comprehensively and tightly regulated, the regulation of shadow banks is not
that extensive and their business operations lack transparency. Third, while
commercial banks, by and large, derive funds through mobilization of public
deposits, shadow banks raise funds, by and large, through market-based
instruments such as commercial paper, debentures, or other structured credit
instruments. Fourth, the liabilities of the shadow banks are not insured, while
commercial banks deposits, in general, en!oy "overnment guarantee to a
limited extent. Fifth, in the times of distress, unlike banks, which have direct
access to central bank li#uidity, shadow banks do not have such recourse.
$hile there may be stark differences in the way the shadow banks
operate as compared to banks, sometimes there is only a thin line separating
the two. For instance a regulated bank may float a Special %urpose &ehicle
'S%&( to hold some specific assets, with a view at removing them from its
balance sheet.
Shadow banks) role in the financial system and their modus operandi
*ike regular banks, shadow banks provide credit and generally increase
the li#uidity of the financial sector. +et unlike their more regulated
competitors, they lack access to central bank funding or safety nets such
as deposit insurance and debt guarantees. ,n contrast to traditional banks,
shadow banks do not take deposits. ,nstead, they rely on short-term funding
provided either by asset-backed commercial paper or by the repo market, in
which borrowers in substance offer collateral as security against a cash loan,
through the mechanism of selling the security to a lender and agreeing to
repurchase it at an agreed time in the future for an agreed price. -oney
market funds do not rely on short-term funding. rather, they are investment
pools that provide short-term funding by investing in short-term debt
instruments issued by banks, corporations, state and local governments, and
other borrowers. The shadow banking sector operates across the /merican,
0uropean, and 1hinese financial sectors, and in perceived tax
havens worldwide. Shadow banks can be involved in the provision of long-
term loans like mortgages, facilitating credit across the financial system by
matching investors and borrowers individually or by becoming part of a chain
involving numerous entities, some of which may be mainstream banks. 2ue
in part to their specialized structure, shadow banks can sometimes provide
credit more cost-efficiently than traditional banks. / headline study by
the ,nternational -onetary Fund defines the two key functions of the shadow
banking system assecuritization 3 to create safe assets,
and collateral intermediation 3 to help reduce counterparty risks and facilitate
secured transactions. ,n the 4S, prior to the 5667 financial crisis, the shadow
banking system had overtaken the regular banking system in supplying loans
to various types of borrower. including businesses, home and car buyers,
students and credit users.
/s they are often less risk averse than regular
banks, entities from the shadow banking system will sometimes provide loans
to borrowers who might otherwise be refused credit. -oney market funds are
considered more risk averse than regular banks and thus lack this risk
characteristic.
The risks associated with shadow banking
/s shadow banks do not take deposits, they are sub!ect to less
regulation than traditional banks. They can therefore increase the rewards
they get from investments by leveraging up much more than their mainstream
counterparts and this can lead to risks mounting in the financial system.
4nregulated shadow institutions can be used to circumvent the strictly
regulated mainstream banking system and therefore avoid rules designed to
prevent financial crises. -oney market funds are highly regulated under
the ,nvestment 1ompany /ct of 89:6, which imposes stricter regulation than
banking regulation.
Shadow banks can also cause a buildup of systemic risk indirectly
because they are interrelated with the traditional banking system via credit
intermediation chains, meaning that problems in this unregulated system can
easily spread to the traditional banking system. /s shadow banks use a lot of
short-term deposit-like funding but do not have deposit insurance like
mainstream banks, a loss of confidence can lead to ;runs; on these
unregulated institutions. Shadow banks) collateralised funding is also
considered a risk because it can lead to high levels of financial leverage. eserve to regulate all
institutions of systemic importance. ,n order to put a control on the
burgeoning shadow banking activities, the 0uropean 4nion has also put in
place some measures, which inter alia include prudential rules concerning
securitisation, regulation of credit rating agencies, etc. Further, at the re#uest
of "-56 countries, at international level, FS< has been working towards
strengthening the oversight and regulation of the shadow banking system so
that the risks emanating from them may be mitigated. &arious other countries,
including ,ndia are working towards improving the regulatory framework so as
to curb the shadow banking activities, which pose a risk to financial stability.
Challenges Posed B Shadow Banks
Though the focus of regulation on shadow banking activities emerged in
the wake of their alleged role in the recent global crisis, shadow banking
system is not a new development. 0ven in the late 89?6s and early 89@6s,
concerns emanating from the growth of non-bank financial intermediaries had
been highlighted AThorn '89?B(. Cogan '89@6(D. Thorn '89?B( had advocated
same degree of control over credit expansion by the E