Every time there is a mention of shadow banking, the mind acts in a biased manner, conjuring up only negative images. Unfortunately, this connection is not without reason: shadow banking is believed to have played a pivotal role in the 2008-subprime mortgage crisis. But, with the conditions having improved significantly since the recession, investors are in risk-on mode and willing to lend and borrow more, in their zest for higher yields. This is where shadow banking makes its way into the financial system and the capital markets.
What is Shadow Banking?
The Financial Stability Board, commonly known as FSB, describes the shadow banking system as the network of entities which works outside the regulated banking system, but performs similar functions. These functions can be wholly summed up into core banking functions and credit intermediations. Credit intermediation is the general banking operation of taking money from saving deposits and lending it to borrowers and can be further classified into:
- Maturity transformation
- Liquidity transformation
- Leverage
- Credit risk transfer
The industry has a sizeable presence with a valuation of 120 percent of the global GDP, as per the Global Shadow Banking Monitoring Report 2014 released by the FSB on 30th October (the complete report is available on: - http://www.financialstabilityboard.org/wp-content/uploads/r_141030.pdf?page_moved=1). The report also revealed that the system had grown by $5 trillion to $75 trillion. The industry includes storefront lenders, real estate investment trusts (REITs), hedge funds, and insurance companies to name the important ones.
Source: www.financialstabilityboard.org
As of end-2013, the United States had the biggest shadow industry, closely followed by UK and China.
The Growth of Shadow Banking
The FSB report mentions that “shadow banking tends to take off when strict banking regulations are in place, when real interest rates and yield spreads are low and investors search for higher returns, and when there is a large institutional demand for assets, for example from insurance companies and pension funds. Hence, the current environment in advanced economies seems conducive to further growth of shadow banking.” With major world economies, barring the US, opting for near-zero interest rates (or devaluation of currencies), and the investors’ risk appetite touching new highs with the booming stock markets, the upward trend of shadow banking looks set to continue.
Are the non-bank financial entities related to the regulated banks?
Since the unregulated banking sector uses similar investment vehicles as the regulated banks, the spillover effect cannot be ruled out. To be more precise, the linkage between the two can be discussed as direct and indirect. Direct linkage can refer to the two industries holding each other’s assets such as the debt instruments. Indirect linkage can be established if both the industries are investing in similar sectors such as the real estate or bonds.
Shadow banking is not a problem, but there are considerable risks
Non-banking lending activities are not a problem if the investors are well-informed of their investments and there are no systemic risks arising out of them. In fact, shadow banking has been the credited with ensuring money supply in developing economies where the banks lack the framework or face frequent regulatory hurdles. In the developed markets such as Europe and US, the unregulated banks are actively lending to borrowers and facilitate deeper market penetration, simultaneously contributing to the spending cycle. The unconventional system is being replicated by some companies on Wall Street. LendingClub, the world’s largest online marketplace for borrowers and savers, had a grand IPO in December, raising $870 million. The online platform uses technology to operate at a lower cost than the traditional banks. Many more companies are expected to follow suit in 2015.
Rewards are always coupled with risks. The risk of interconnectedness is one of prime consideration. During periods of economic crisis, investors might want to withdraw quickly from short-term and long-term funds. Hence, the shadow banks resort to panic selling to repay the investors which cause a severe depreciation in various asset classes. This bedlam soon engulfs the regulated banking sector as they too own similar investments and run into serious losses, including bankruptcy. The bankruptcy of Lehman Brothers Holdings Inc. is one such case. Also, with enormous, unaccounted funds flowing in and out of the financial system, it becomes incredibly tough to reign in forex volatility. In present times, Japan is a source of worry as the number of highly leveraged brokers/dealers has increased manifold. In Eurozone and US, massive fund flows were seen in bond funds, mixed funds, and other funds, which grew at their fastest pace in the past 5 years. According to the IMF’s October 2014 Global Financial Stability Report (GFSR), “in the United States, shadow banking accounts for at least a third of total systemic risk. This contribution has been growing since the global financial crisis.” This contribution is much smaller elsewhere in UK and euro region, indicating the presence of more traditional banking systems. In the emerging markets landscape, China continues to witness an aggressive expansion of the shadow industry even in the recent slowdown, warranting a close inspection by the officials.
Since it is free from regulations, it seems highly difficult to gauge the correct extent of the industry and hence, nearly impossible to predict the exact risks associated and their potential impacts. Hence, governments which are seeing a surge in the shadow banking industry have begun tightening the noose. Yi Gang, vice-governor at the People’s Bank of China revealed this week that “the central bank was closely monitoring shadow banking”, as economic growth stooped to a 24-year low. It has been widely anticipated that the explosive growth in China’s housing sector was due to the shadow system, which is pegged at around $4.5 trillion.
Things are improving but, may take time!
If the shadow banking industry can be regulated or even isolated, such systemic risks are greatly reduced with benefits staying intact. Keeping this thought close, the FSB has been urging for a regulatory reform agenda for the shadow industry. Though the agenda has yielded important progress, many of the agreed principles, such as considering the intricacies of the shadow entities, are yet to be implemented. The authorities are working to bring forth a framework, but owing to the paucity of accurate data, it may take time.