After the great depression and the Glass-Steagal Act, commercial banks were tightly regulated in order to safeguard stability of the financial system. Conventional banks are more regulated, closely monitored, better capitalised and less leveraged than they were few decades ago. On the other hand, the same can't be said of what's come to be known as shadow banking. From hedge funds, asset managers and pension funds to insurers, money market funds, real estate funds and many others doing exactly what conventional banks routinely do, take money from one party and lend it to another. Yet many of these activities remain in the shadows, not subject to inspection and prudential regulation imposed on banks. There is also the issue of maturity transformation through which funding for long-term loans was being provided by short-term customer investments and liquidity transformation, whereby money from short-term depositors is turned into illiquid assets, preventing them from cashing out when they need to.
In the US, the shadow banking sector is nearly the same size as the formal banking sector, although it has contracted over the past decade. The shadow sector now accounts for perhaps 30-40 per cent of total financial intermediation. Nonbank lenders, often called shadow banks, now have US$52 trillion in assets, a 75 per cent increase since the financial crisis. The industry was at the center of the financial crisis when the subprime mortgage market collapsed.
Regulators and economists are wary of shadow banking as these entities usually lack safety nets such as deposit insurance, a lender of last resort and sufficient regulatory oversight. Why is shadow banking viewed with suspicion? Shadow banks are able to encourage economic activity by making loans cheaper by lowering operating costs and more accessible by offering services to customers that banks may not or will not serve. However, this flexibility and price competitiveness often comes at the expense of an adequate safety net; banks are required to maintain certain levels of capital and liquidity which makes them safer but shadow banks are not required by law to do so. Also, they choose to assume more risks by lending to riskier customers which makes them susceptible to risky behaviour. In reality, however, these entities were dependent on the banks which owned them as their primary assets were risky securitised loans.
Shadow banks do not have any kind of backup that would save them from trouble if the depositors suddenly want to withdraw their cash whereas all depositors' funds are duly insured in commercial banks. However, it is difficult for them to divert cash towards their shadowy wing especially if there is an evolving crisis. This creates a situation wherein shadow banks not only face huge risks themselves but also pose systemic risk and they 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 liquidated with immediate effect. This creates a situation of distressed sales; firstly, the shadow bank itself has to book losses on these distressed sales, and, secondly, the assets start trading at a lower market value due to the sudden increase in supply.
As such, what are the risks associated with shadow banking? As shadow banks do not take deposits, they are subject to less regulation than traditional banks. They can therefore increase the rewards they get from investments by leveraging up much more than their mainstream counterparts and this can lead to risks mounting in the financial system. Unregulated shadow institutions can be used to thwart the strictly regulated mainstream banking system and therefore avoid rules designed to prevent financial crises. As shadow banks use a lot of short-term deposit-like funding but do not have deposit insurance like mainstream banks, a loss of confidence can lead to run on these unregulated institutions. Shadow banks' collateralised funding is also considered a risk because it can lead to high levels of financial leverage. If so, there remains any upside to shadow banking?
The answer is, not all shadow banking is daunting. Shadow banks provide liquidity where commercial and investment banks cannot, which if everyone understands the risks involved are probably a good thing. Accordingly, shadow banking essentially operates alongside commercial banks, financing investments and adding liquidity where it might not otherwise be forthcoming. It is also important for the economy because it provides funding to traditional banks and without this funding, traditional banks would not lend money, which would then slow down growth in the wider economy. Shadow banking institutions like hedge funds often take on risks that mainstream banks are either unwilling or not allowed to take. This means shadow banks can provide credit to people or entities who/that might not otherwise have such access. 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. Additionally, shadow institutions enabled by shadow banking leads to a lower cost of capital for firms, greater investment, and a higher level of economic growth. Moreover, during a shadow banking boom, the economy moves up the risk-return frontier, funding riskier but more productive investments and over time, this process builds up fragility in the financial system.
At the peak of a shadow banking boom, even a modest shock can set off a drop of adverse events. Faced with increased uncertainty, investors are no longer willing to hold shadow banking securities whose liquidity could easily disappear and subsequently shut down. The liquidity crunch forces discount rates up and asset prices down. The instability of prices drives up margins, leading to a downward spiral that exacerbates collateral shortage and liquidity crunch. The end result is that capital investment falls and the economy enters a deep recession.
Dilemma with shadow banking is: while it makes good times better, it also makes bad times worse. According to economists, shadow banking imposes a negative externality on the rest of the economy. During the boom, individual institutions have little incentive to take into account the impact of their actions on the severity of the bust. Government and international institutions have to take some strict decisions for this sector; otherwise we are going to face a much bigger crisis than 2008, and this time the volume of credit will be so huge that typical rescue packages won't be able to cover up.
Md. Harun-Or-Rashid is Manager Operation at Social Islami Bank Limited (SIBL)