What is Shadow Banking?

Understand Key Risks to the Global Financial System

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Most people go to a bank when they are looking to deposit or loan money, but there are many other options available to the public. In 2007, PIMCO Economist Paul McCulley coined the term “shadow bank” to refer to non-bank financial institutions sold loans that were repackaged as bonds. These financial institutions aren’t commercial banks, so they cannot borrow emergency funds from the Federal Reserve and often don’t have insurance.

In this article, we’ll take a closer look at the shadow banking system, risks to the global economy, and some important considerations for international investors.

Shadow Banking 101

The term “shadow banking” was widely used during the 2008 financial crisis to describe financial institutions that were securitizing mortgage loans. Since the original mortgage was bought and sold by various entities, the term “shadow” was used to refer to the fact that these transactions took place outside of the view of industry regulators. These transactions became problematic when parties began to find it difficult to accurately value the assets.

There are four key techniques commonly employed by shadow banks:

  • Maturity Transformation – Obtaining short-term funds to invest in long-term assets.
  • Liquidity Transformation – Using cash-like liabilities to buy illiquid assets like loans.
  • Leverage – Borrowing capital to buy fixed assets to magnify gains.
  • Credit Risk Transfer – Transferring the risk of a loan to another party.

During the 2008 financial crisis, many of these techniques caused major problems for both shadow banks and commercial banks that became intertwined with them. Investors demanding cash put strain on shadow banks using liquidity transformation and maturity transformation and forced them to sell assets at fire “sale prices”.

These sales devalued those assets across the market and led to problems for many commercial banks holding similar securities.

Since the crisis, shadow banking has been expanded to include nearly any bank-like activity that’s not provided by a regulated bank. Examples of these organizations include payday lenders, mobile payment systems, pawn shops, peer-to-peer lending websites, bond trading platforms, and even some hedge funds and asset management companies. Many of these companies are flourishing as traditional banks face increased regulations.

International Issues

The term “shadow banking” may have been coined during the U.S. 2008 financial crisis, but the concept exists in many different markets around the world.

China’s shadow banking sector began offering above-average yields on deposits in a move that ended up causing a series of stock market crashes. After promising high fixed returns, these shadow banks attracted billions of dollars from Chinese savers that ended up inflating stock valuations. These shadow banks employed high amounts of leverage in an attempt to maximize their profits and were unable to easily unwind the problems when the market crashed.

In May 2015, the European Central Bank warned about the risks posed by the shadow banking sector in Europe.

The central bank indicated that the sector’s Eurozone assets more than doubled to 23.5 trillion euros over the past decade. With the ECB’s quantitative easing efforts and restrictions on banking, shadow banking activity has become a target for investors seeking yield and some assets have become overvalued as a result of excessive leverage.

Regulating the Industry

The good news is that several domestic and international regulatory bodies have been working to regulate and contain the shadow banking industry since the 2008 financial crisis.

In the United States, the Federal Reserve has been mapping relationships within the shadow banking sector in order to determine the scope of the problem. At the same time, the Financial Stability Oversight Council – created by Dodd-Frank – has been working up regulations to help contain the sector and avoid any potential issues down the road.

The problem is that these groups may have cast their nets too wide to include normal transactions.

Internationally, many countries have begun to take actions to measure the size of and contain their shadow banking sectors. Chinese regulators took action to control credit expansion in its shadow banking sector and has been moderately successful to date. The European Central Bank has also outlined plans to try and regulate the sector and warned the industry of potential issues that may arise if the sector continues to grow unconstrained.

The Bottom Line

Shadow banking may have been coined in 2007, but these practices have existed for many years. While growth in the sector has continued to expand, regulatory across many countries have been successful in slowing the growth through some regulation. International investors should be aware of the impact of the shadow banking sector in various countries, particularly when it comes to inflating asset valuations.