Shadow Banking: Not Illegal

April 20, 2020

Understanding Shadow Banking: Not Illegal, Less Regulated

Professor Shah Ahsan Habib[1]

Though the focus of regulation on shadow banking activities emerged in the wake of their alleged role in the recent global crisis, shadow banking system is not a new development. It is well recognized that the activities of banks and financial institutions must be highly regulated and monitored. Effective regulatory and supervisory framework in a country is to effectively control the intermediation process by undertaking limited risks and thus interests of the small depositors (creditors) of the banks can be protected. Credit intermediation by nonbanks may take place without the prudential regulation and supervision required for a bank. If aggregate level of such credit intermediation is significant in a given country, accumulated losses among nonbanks could affect confidence in the banking sector as well, particularly when the common people are not aware which institutions are supervised and which are not. Banking sector stability could be substantially affected when there are significant market interconnections between banks and nonbanks.

The term ‘Shadow Banking’ received popularity following 2006-07 in connection with the engagement of some non-bank financial institutions of USA in maturity transformation. It was coined in 2007 by Paul McCulley to describe risky off-balance-sheet vehicles hatched by banks to sell loans repackaged as bonds. Paul McCulley, referred ‘shadow banking’ as to ‘the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures which roughly describes the world of structured finance, which creates and utilizes these types of conduits, vehicles and structures collectively mean ‘special purpose entities’. In the same line, the term was widely used during the 2008 financial crisis to describe financial institutions that were securitizing mortgage loans, and during crisis, many of these techniques caused major problems for both shadow banks and commercial banks that became intertwined with them. However, recent literature displayed wider scope and catalysts of the development of shadow banking in the context of almost all global economies.

It is commonly said that the main catalysts of the shadow banking are technology and the innovation. It is believed that the rise of shadow banking partly stems from erosion of banks’ informational and transactions cost advantages over nonbanks, owing to improvements in technology. While traditional banks have the capacity to respond, sooner or later, to investor demand for products, technology has enabled non-bank financial market participants to compete with traditional banks in providing these products quickly and at lower cost. Shadow banks have flourished in part because the traditional ones, battered by losses incurred during the financial slump; and tighter capital requirements and fear of heavy penalties have kept them grounded.

Within the banking industry, regulatory arbitrage is often cited as an important driver of the growth of shadow banking. Arbitrage involves transactions or strategies designed to exploit differences or gaps within or between regulatory regimes.  Given regulatory constraints on banks’ on-balance sheet activities, particularly the capital requirements banks are subjected to, there might be tendencies of shifting to the off balance sheets activities in order to conserve capital. Using shadow banking activities such as holding structured finance vehicles, banks are able to boost their expected returns by circumventing stringent capital requirements and achieve higher leverage than permitted under prudential regulations. Moreover, the off-balance sheet vehicles (special investment vehicles and the conduits) also enable banks to evade disclosure and accounting requirements, disguising the economic reality of risks being taken. The divergences in the regulatory and legal structures across different economies meant that leverage and risks not only increased through off-balance sheet transactions, but also offshore activities, with the incentive to avoid tax, capital, accounting and regulatory requirements. While regulations remain confined to national borders, shadow banking operations are embedded across borders on a global scale. The literature has also recognized that reserve requirements imposed a disadvantage on banks that spurred the growth of money market mutual funds and other alternatives to bank deposits. However, financing by non-bank not always be a bad thing as they offer additional sources of credit to individuals and businesses in countries where formal banking is either expensive or absent.

In recent years, several definitions have been put forward for shadow banking in different country contexts and by different institutions and authors. In spite of agreements on various aspects, there are clear differences in the conceptualization and impact of shadow banking activities. Definitions of ‘Shadow Banking’ vary widely in the context of different groups of financial market stakeholders from their perspectives; and thus attempts to define and measure shadow banking take several approaches. Shadow banking activities are commonly perceived as unregulated activities by the regulated institutions; and these banks or institutions act like banks however are not supervised like banks and are out of the traditional scope of banks’ regulations.

There are very wide and narrow versions of interpretation on shadow banking concepts. As broad definition shadow banking includes all financing activities that are allowed but less regulated. Some definitions on shadow banking focus on certain instruments only like three basic instruments of the shadow banking industry are: money market funds, repos and collateralized securities issued by structured finance vehicles. The Financial Stability Board or FSB defines shadow banking as, ‘credit intermediation involving entities and activities outside the regular banking system.’ -in other words, lending by any entity other than a bank.

In some definitions shadow banking has been activities are defined as  ways of taking deposits, extending credit, and making payments that do not use the conventional and traditional banking methods;  and very often these ways of taking deposits, extending credit and making payments, are not regulated or, at least, not regulated very much. Sometimes shadow banking is perceived as illegal banking which is not true as per the recognized definitions. Shadow banking is neither illegal nor unethical. Sometimes it is complex and is less regulated. Rather, on a positive note, shadow Banking is seen as an approach to address unmet credit demand. That is, the liabilities that shadow banks create help address the need for collateral in financial markets, and that shadow banks help address some credit demands unmet by commercial banks.

Practically, most academics and central bankers use the term ‘shadow banking’ narrowly to mean forms of lending that closely resemble banking. Bankers commonly take the shadow banking in a much more sweeping way, to refer businesses to boost profits through cutting regulatory corners by the by the bank like entities.

There are efforts to make distinction between ‘banking’ and ‘shadow banking’ using characteristics. However, discussion of the characteristics of ‘Shadow Banking’ must necessarily be tentative because it lacks a concrete definition of shadow banking; nonetheless as distinctive features it can be noted that  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. 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.

[1] Director (Training), BIBM ([email protected]).

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