Shadow Banking System

A collection of non-bank financial intermediaries (NBFIs) that provide services similar to commercial banks

The Shadow banking system is a collection of non-bank financial intermediaries (NBFIs) that provide services similar to commercial banks but are not subject to banking regulations.

Shadow Banking System

Non-bank financial intermediaries are financial institutions that do not have a full banking license or are not monitored by a national or international banking regulatory organization.

They provide credit and liquidity like traditional banks but do not have access to central bank funding. Examples of NBFIs are hedge fundsmoney market fundsstructured investment vehicles, and unique purpose entities.

Shadow banking refers to bank-like activities (primarily lending) outside the traditional banking sector. The word "shadow" denotes that the operations of the NBFIs are not as transparent to the public as regular banks. 

In 2007, economist Paul McCulley of the bond investment firm PIMCO came up with the term "shadow banking." He used the word to talk about how NBFIs are becoming more critical to the economy.

According to some, the financial system's overreliance on leverage and risk due to shadow banking contributed to the 2008 financial crisis.

With no capital requirements or last resort credit lines from central banks, many financial institutions with poor regulation and supervision began to generate more significant risks.

Global shadow banking systems and markets were created due to the interaction of these institutions and marketplaces that aren't subject to central banking regulations.

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Like commercial banks, shadow financial institutions use short-term funds to make longer-term loans. However, they do not have deposits to lend to borrowers because shadow banks are not depository institutions.

In the traditional banking system, a bank's lending volume is proportional to the size of deposits it receives and the amount it can borrow on the markets. The same principle can be applied to the shadow banking system.

Shadow banks collect investment funds from investors to purchase long-term investments, such as securities, to generate a return on investment.

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In essence, shadow banks act as intermediaries between borrowers and lenders and profit from the interest rate differential and fees they charge for their services.

Shadow banks were scrutinized because of their increased involvement in turning home mortgages into securities.

The securitization of mortgages is a process in which individual mortgages are bundled into mortgage-backed securities that are then sold to investors.

Mortgage-backed security (MBS) 's value is linked to the value of the mortgage loans included in the package. The fixed income paid to MBS investors comes from the homeowners' interest and principal payments on their mortgage loans.

Nearly the entire process of mortgage securitization, including mortgage establishment and security selling, happened outside regulators' direct line of sight.

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Issues of Shadow Banking System

The Federal Deposit Insurance Corporation (FDIC) does not protect investor funds gathered through a shadow banking business as opposed to deposits in a traditional bank. As a result, the shadow banking system raises some severe issues for investors and the financial system.

Discussion

Some of the problematic issues caused by shadow banks are:

1. Potential Liquidity Problems

The subsistence of all banks and monetary institutions depends on short-term capital access, which allows these financial entities to fulfill their financial obligations and meet their liquidity needs.

However, unregulated financial institutions cannot access the funding sources of their regulated counterparts. If short-term funding becomes unavailable, unregulated institutions will face severe liquidity problems and could even fail in a short amount of time.

The liquidity problems originating from the shadow banking system are precisely what made the 2008 financial crisis so severe. We will touch on this more later in this article.

2. Safety Issues for Investors

FDIC-secured deposit accounts and money market accounts are generally considered safe for depositors. In contrast, the funding source of unregulated institutions is not insured by FDIC, which would not be a problem in regular times.

However, if something like the 2008 financial crisis arises suddenly, unregulated financial entities cannot borrow funds from the central bank to give money back to the depositors.

Unlike traditional banks, the unregulated banking sector had no loss-absorbing capital or redemption cash, minimal supervisory control from regulatory agencies, and no access to official liquidity support to prevent fire sales.

Without access to government-backed funding, shadow banking institutions must sell their assets at a lower price to pay back investors' money, as happened in 2008. However, selling assets at a lower price could lead to recessions that harm the global economy.

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3. Can Lead to Recession

As mentioned above, shadow banks can significantly impact the severity of a financial crisis, like what happened in 2008.

The catastrophic liquidity problems that led to the 2008 financial crisis were caused by shadow banking institutions like Lehman Brothers and Bear Stearns rather than the run on traditional banks in the Great Depression of the 1930s.

4. Distressed Sales

In an economic downturn, investors become uncertain about their investments and want their money back. As a result, shadow banks must sell their assets to pay back investors when this happens.

Fire sales decrease the value of the assets, which compels other shadow banking firms holding similar assets to drop their book values to reflect the lower market price leading to severe financial difficulty.

5. Financial System Risk

Unregulated banks connect with the standard banking system via credit intermediation chains. Therefore, problems caused by the shadow banking system could impact the whole financial system and indirectly contribute to a financial crisis.

6. High Leverage Rate in the Economy

Funding provided by shadow banks is also viewed as a risk because it might lead to a higher rate of financial leverage in the economy. A high rate of power in the economy could potentially result in a damaging downturn.

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Benefits of Shadow Banking

1. Maintain Financial Stability

Shadow banking may contribute to financial stability by taking uninsured and uninsurable deposits from the commercial banking industry, narrowing bank runs' scope.

Most people who use shadow banks are institutional investors who keep a lot of cash on hand and can't or don't want to put their whole reserve fund in insured banks because of the limit on deposit insurance.

In other words, shadow banks function as hedge funds or trading houses, contributing to the economy by financing risky investors that traditional banks don't accept.

2. Promote Diversification in the Financial System

Shadow banking institutions reduce the need to obtain credit from established banks because they serve as an additional source of lending that leads to diversification in the financial system.

Shadow banks offer a lot of services similar to traditional banks. For example, they advance loans to their clients without securities. These loans have the potential to generate long-term profits and, as a result, command high market prices.

Moreover, they establish credit and make deposits and withdrawals to members using the same recognition. They provide mortgages and other financial consulting services like customer counseling and cash flow management.

Furthermore, shadow banking institutions finance small or medium-sized firms generally rejected by traditional banking. Shadow banking has been a tremendously important source of finance for firms on the edge of bankruptcy or insolvency.

3. Shadow Banking's Business Model Is Superior to Traditional Banking in Terms of Financial Stability

Traditional banking's business strategy involves taking advantage of the interest rate difference between the money they borrow and the money they receive.

As long-term interest rates are often higher than short-term ones, banks primarily fund themselves through short-term borrowing while giving borrowers long-term loans.

Banks' earnings may be squeezed and decrease quickly when short-term interest rates rise rapidly, causing them to either reduce funding or raise borrowing charges.

In contrast, most shadow banking institutions issue shares to investors to raise funds. As long as investors do not collectively redeem equity shares from the institutions, there are fewer issues over appropriate funding in a short period.

4. Higher Growth Rate

Traditional banking development has slowed due to cost restrictions, whereas shadow banking growth accelerates because of arbitrage from regulation.

Shadow banks do not maintain a minimum amount of deposits as lending collateral because they are not subject to the law. In addition, the rates of shadow banks are lower than traditional banks.

Shadow Banking and Financial Crisis

The unregulated banking system has been blamed for being the primary cause contributing to the housing market collapse and the financial crisis in 2008.

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Timothy Geithner, who served as the president and CEO of the New York Federal Reserve Bank from 2009 to 2013, attributed most of the blame for the credit markets freeze that led to the 2008 crisis's run on the unregulated banking system.

The unregulated entities had become dangerously overextended via their lending business. But, at the same time, the increased dependency on off-balance-sheet lending had made these unregulated entities crucial to the credit markets that support the entire financial system.

These organizations unlimitedly took out short-term loans in stable markets to buy long-term, illiquid assets, which made them susceptible to rapid deleveraging. Then, when they faced a liquidity issue, they had to sell their long-term investments at depressed prices.

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It is argued that the 2008 financial crisis happened partly because of the lack of regulations in shadow banking. Loose rules permitted shadow banks to operate with higher liquidity and credit risks, eventually leading to the subprime mortgage meltdown.

Following the global financial crisis, the traditional banking sector was ordered to shrink its lending activities as regulatory scrutiny tightened and more restrictions were imposed on banks.

Interestingly, the increasingly strict lending environment has increased demand for alternative funding sources, resulting in more unregulated financial institutions operating outside the constraints of banking rules.

Since unregulated banks impact the traditional financial sector and the economy, banking authorities investigate the exposure of conventional banks to unregulated banks.

Based on this investigation, banking authorities attempt to restrict the exposure of unregulated banks through stricter capital and liquidity regulations.

In addition, many authorities have broadened the purview of information reporting, and some have altered the regulatory perimeter to capture shadow-banking entities.

Key takeaway

Takeaways

  • The shadow banking system is a collection of unregulated financial institutions that provide services similar to commercial banks but are not subject to banking regulations.

  • It provides credit and liquidity like traditional banking but does not have access to central bank funding.

  • Since shadow banks are not depository institutions, they don't have deposits to lend to borrowers. Instead, they get the money they need from investors.

  • The FDIC does not protect investor funds gathered through the unregulated banking business. Therefore, it poses severe issues to investors and the financial system.

  • Some advantages of shadow banking include:

    • It serves as an additional lending source and promotes diversity in the financial system.

    • It grants credit to those who would not otherwise be able to obtain money from traditional banks.

    • Shadow banking institutions can take as much risk as they choose without worrying about breaking the law.

  • Some disadvantages of shadow banking include:

    • In an economic downturn, unregulated banks must sell their assets to give back investors' funds. 

    • Funding provided by unregulated financial institutions might lead to a higher rate of financial leverage.

    • Credit intermediation chains link unregulated financial institutions to the rest of the banking system. Thus, problems in the shadow banking system could affect the whole banking system and indirectly impact the economy.

  • The shadow banking system has been blamed for being the primary cause contributing to the housing market collapse and the financial crisis in 2008. 

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Researched and authored by Khadega Bazarah | Linkedin

Reviewed and Edited by Hongmo Liu | LinkedIn

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