The Guide to Shadow banking - Banking Info

What is Shadow Banking

Shadow banking refers to all the non-bank financial intermediaries that provide services similar to those of traditional commercial banks. They generally carry out traditional banking functions, but do so outside the traditional system of regulated depository institutions. Shadow banking has grown in importance in the last decade or so and was one of the primary factors in the sub-prime mortgage crisis of 2007-2008 and the global recession that followed it.

Shadow banking institutions generally serve as intermediaries between investors and borrowers, providing credit and capital for investors, institutional investors, and corporations, and profiting from fees and/or from the arbitrage in interest rates.

In India, Russia, Argentina, Turkey, Indonesia, and Saudi Arabia the amount of non-bank financial activity remained below 20% of GDP at the end of 2012. However, the sector is growing rapidly.

Differences between Shadow Banks and Banks

• Shadow banks cannot create money unlike commercial banks, which by virtue of being depository institutions can do so
• Banks are comprehensively and tightly regulated, whereas shadow banks lacks regulatory oversight and transparency with respect to its business operations
• Commercial banks raise funds through mobilization of public deposits to a large extent. Shadow banks, on the other hand, raise funds mostly through market-based instruments such as commercial paper, debentures, or other such structured credit instruments
• While the liabilities of the shadow banks are uninsured, commercial banks’ deposits enjoy Government guarantee to a limited extent generally
• During times of distress, banks have access to multiple recourses set up by the body responsible for regulatory oversight such as direct access to central bank liquidity etc. However, shadow banks have no such options, and will have to fend for themselves
• There is a stark differences in the way the shadow banks operate as compared to other traditional banks. However, in certain instances there is only a thin line separating the two.

Functions of Shadow Banks

The three defining functions that must be performed by any institution in order to be called a shadow bank are as follows:

• The shadow bank must issue short term securities and use the proceeds to buy longer term assets. Now the question arises as to why would lenders buy short term risky securities of an unknown corporation? Well they do not have to. A lot of these shadow banks are implicitly or explicitly backed by commercial banks and therefore command the sort of confidence that is required to sell securities in the government markets.
• The shadow banking institution must be have liabilities which are liquid and assets which are relatively illiquid
• The shadow bank must use further leverage while making investments. These investments can be made by raising money from other institutions.

What are the Advantages of Shadow Banking System

• No regulation: There is only one huge advantage to having the shadow banking system i.e. no regulation. Since the banking industry is so regulated, this advantage is big enough to offset hundreds of disadvantages on its own.
• No regulation on the money raised by selling securities allows the shadow banks to take as much risk as they would like to without defaulting on their obligations. Compliance procedures and reports which cost millions of dollars as well as disruption of operations are no longer required.

What are the Disadvantages of Shadow Banking System

• No Access to Cash:
• Shadow banks are not backed by the central bank. As a result, they do not have any kind of backup that would save them from trouble if the depositors suddenly wanted to withdraw their cash. It is true that commercial banks indirectly back these shadow banking institutions. However, it is difficult for them to divert cash towards their shadowy arm especially if a crisis is in progress. This creates a situation wherein shadow banks not only face huge risks themselves but also pose systemic risk. This is because their business creates the same amount of risk as that of banks. However, they do not have the preventive regulations or the safety nets that banks have access to in case things start going wrong.
• Distressed Sale:
• Shadow banks buy long term assets and finance them by selling short term securities. However, if investors become wary about a bank’s health, these long term assets have to be liquidates with immediate effect. This creates a situation of distressed sales.
• Firstly, the shadow bank itself has to book losses on these distressed sales. Secondly, the assets start trading at a lower market value due to the sudden increase in supply. Therefore, other banks which are holding such assets also have to mark down their balance sheet. This creates a downward spiral wherein perceived losses create actual losses. This is why shadow banks are said to pose “systemic risk” to the actual banking system. However, the allure of no regulation is so strong that these banks have not been eradicated from the system till now.
• Salvage Reputation:
• The 2008 meltdown exposed a lot of links between the commercial banking system and the shadow banking system. This is because when these shadowy banks started going bust, they were often bailed out by commercial banks. Commercial banks would do so in order to maintain their reputation in the money market so that they can continue their operations in the future.
• However, as a result of the 2008 expose, very few banks are now willing to indulge in shadow banking. Any bank seen as having exposure to shadow banks, immediately witnesses a drop in its share prices as well as large cash withdrawals. However this phase is only temporary and has happened multiple times before. Shadow banking system seems to expand and contract, however as mentioned above, it does not vanish!