SHADOW BANKING
Recently, Janet Yellen (US Federal Reserve’s chair) has voiced an alarm that shadow banks pose “a huge challenge” to the world economy. Economists across the globe have also unanimously agreed that if shadow banking is left to its own devices, it has the potential to trigger another financial collapse. Shadow banking, in fact, symbolizes one of the many failings of the financial system leading up to the global crisis.
Shadow banks first caught the attention of many experts because of their growing role in turning home mortgages into securities. These are described as risky off-balance-sheet vehicles hatched by banks to sell loans repackaged as bonds.
EMERGENCE
The term “shadow bank” was coined by economist Paul McCulley in a speech at Federal Reserve Bank in 2007 , referring mainly to nonbank financial institutions in USA that engaged in maturity transformation i.e. they use deposits, which are normally short term, to fund loans that are longer term.
Shadow banks have flourished because the traditional ones, battered by losses incurred during the financial slump, are under pressure. In China, where banks are discouraged from lending to certain industries and are mandated to offer frustratingly low interest rates on deposits, these non-banks fill the gap.
Today, the term is used more loosely to cover all financial intermediaries that perform bank-like activity but are not regulated as one. These financial intermediaries include mobile payment systems, pawnshops, peer-to-peer lending websites, hedge funds and bond-trading platforms set up by technology firms. Among the biggest are asset management companies.
MEANING AND COMPONENTS
They mostly borrow and raise short-term funds in the money markets and use these funds to buy assets with longer-term maturities.
They are called “shadows” because they are not subject to traditional bank regulation and cannot borrow in an emergency from the Central bank and do not have traditional depositors whose funds are covered by insurance.
The Financial Stability Board (FSB), an organization of financial and supervisory authorities from major economies and international financial institutions, developed a broader definition of shadow banks that includes all entities outside the regulated banking system that perform the core banking functions and credit intermediation. It implies taking money from savers and lending it to borrowers.
Its four key aspects and components are :
1. Maturity transformation
obtaining short-term funds to invest in longer-term assets
2. Liquidity transformation
it entails using cash-like liabilities to buy harder-to-sell assets such as loans
3. Leverage
employing techniques such as borrowing money to buy fixed assets to magnify the potential gains (or losses) on an investment
4. Credit risk transfer
taking the risk of a borrower’s default and transferring it from the originator of the loan to another party.
WHY ARE THEY RISKY ?
The shadow banking entities are risky because they are characterized by :
1. A lack of disclosure and information about the value of their assets or sometimes even about the assets themselves.
2. Opaque governance and ownership structures between banks and shadow banks.
3. Little regulatory or supervisory oversight of the type associated with traditional banks.
4. Virtually no loss-absorbing capital or cash for redemptions.
5. Lack of access to formal liquidity support to help prevent fire sales.
WHAT IS THE CONCERN ?
The Financial Stability Board estimates showed that globally, the informal lending sector serviced assets worth $80 trillion in 2014 and it is increasing sharply.
The shadow banking system appears to be largest in the United States, but nonbank credit intermediation is present in other countries and in fact it is growing.
The concern is that many such investors either withdraw or not roll over and reinvest their funds. This makes the financial institutions—banks and nonbanks— vulnerable to further shocks and global instability.
For example , problems arose during the recent global financial crisis when the investors became skittish about what those longer-term assets were really worth and many decided to withdraw their funds at once.
To repay these investors, shadow banks had to sell assets. These “fire sales” generally reduced the value of those assets, forcing other shadow banking entities and some banks with similar assets, to reduce the value of those assets on their books to reflect the lower market price, creating further uncertainty about their health.
Thus, it has the potential to trigger another financial collapse.
WAY FORWARD
Tighter capital requirements and fear of heavy penalties can keep them grounded.
All potential shadow banking entities or activities should be overseen in a way that discourages shadow banks from tailoring their behavior to come under the supervision of the weakest or of no regulators—domestically or globally.
Banking supervisors should examine the exposure of traditional banks to shadow banks and try to contain it through avenues such as capital and liquidity regulations.
However, Non-bank financing need not always be a bad thing. It offers an additional source of credit to individuals and businesses in countries where formal banking is either expensive or absent. It also takes some burden off banks which have big “maturity mismatches” . Thus, their potential can be utilized after bringing them under regulations and scanning.
