Shadow banking refers to the financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.
Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments. Examples of unregulated activities by regulated institutions include credit default swaps.
The shadow banking system has escaped regulation primarily because it did not accept traditional bank deposits. As a result, many of the institutions and instruments were able to employ higher market, credit and liquidity risks, and did not have capital requirements commensurate with those risks. Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations.
Shadows can be frightening because they obscure the shapes and sizes of objects within them.
If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck—or so the saying goes. But what about an institution that looks like a bank and acts like a bank? Often it is not a bank—it is a shadow bank.
Shadow institutions typically do not have banking licenses; they do not take deposits like a depository bank would and therefore are not subject to the same regulations. Complex legal entities comprising the system include hedge funds, structured investment vehicles (SIV), special purpose entity conduits (SPE), money market funds, repurchase agreement (repo) markets and other non-bank financial institutions.
Many shadow banking entities are sponsored by banks or are affiliated with banks through their subsidiaries or parent bank holding companies. The inclusion of money market funds in the definition of shadow banking has been questioned in view of their relatively simple structure and the highly regulated and un-leveraged nature of these entities, which are considered safer, more liquid, and more transparent than banks.
Risks Associated with Shadow Banking
As shadow banks do not take deposits, they are subject 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.
Unregulated shadow institutions can be used to circumvent the strictly regulated mainstream banking system and therefore avoid rules designed to prevent financial crises. Money market funds are highly regulated under the Investment Company Act of 1940, 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.
As 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’ collateralized funding is also considered a risk because it can lead to high levels of financial leverage. By transforming the maturity of credit—such as from long-term to short term—shadow banks fueled real estate bubbles in the mid-2000s that helped cause the global financial crisis when they burst.
Leverage is considered to be a key risk feature of shadow banks, as well as traditional banks. Leverage is the means by which shadow banks and traditional banks multiply and spread risk. Money market funds are completely un-leveraged and thus do not have this risk characteristic.
The authorities are making progress, but they work in the shadows themselves—trying to piece together disparate and incomplete data to see what, if any, systemic risks are associated with the various activities, entities, and instruments that comprise the shadow banking system.
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