Abstract
Through this article, an overview on Shadow Banking has been presented, wherein I review the mechanisms and features of shadow banking and explain the functioning of shadow banking institutions and activities. The role of Shadow Banking in the 2008 financial crisis has also been discussed.
Introduction
Shadow Banking, in layman’s terms, refers to financial institutions that act like banks but are not supervised like banks. These institutions provide services similar to those of traditional commercial banks but are not held accountable to the same standards,risks,liquidity and regulations which commercial banks have to face.
Examples of shadow banks which are not subject to regulation include hedge funds, insurance firms, private equity funds and mortgage lenders.
Shadow Banks are key players in the financial system of the world due to their size, interconnection with the other banks and the huge impact they have had on the economy in the past.
Mechanism Of Shadow Banking:
To fully understand the Shadow banking system, it is imperative to know how commercial banks work. Commercial banks, as any other financial intermediary, are institutions which act as middlemen between lenders and borrowers. To do this, they get financing from their clients ( i.e the lenders) through deposits and extend loans to economic agents. These commercial banks engage in maturity transformation when they use deposits, which are usually short term, to fund loans that are of long term nature.
Banks as financial intermediaries
The banking model shown in figure 1 suffers from several problems. First, the asset held by the bank (loan to the borrower) may be long term while the liabilities of the bank (deposits held by lenders) can be withdrawn on demand. This creates a mismatch between the features of assets and liabilities of the bank. The lender might also not benefit from the deposit as it may earn no interest in case of a current account, or the interest rate might be extremely low.
To overcome these problems, another banking system was conceived where shadow banks act as intermediaries between lenders and the bank. These shadow banks may be pension funds or insurance companies which collect deposits from lenders and then further lend these deposits to the banks, which then lend it to the final borrower.
The Shadow Banking Model with Repo Arrangements
In order to provide sufficient security to the shadow bank, the commercial bank enters into a repurchase (repo) agreement with the shadow bank in which a government security is sold to the shadow bank in exchange for the deposit with a promise to repurchase it back at a future date. In case of default by the commercial bank, the shadow bank can sell the government security in the market and realize it’s money value.
Functions of Shadow Banks:
According to a detailed study by the International Monetary Fund, Shadow Banks carry out mainly 2 key functions :
- Securitization : This is a financial practice which involves pooling various types of assets and repackaging them into securities which bear a reasonable interest rate. Shadow banks carry out securitization by purchasing loans from the commercial banks and converting them into securities which can be sold to investors.
A great example of a type of shadow bank which is known for carrying out securitization is the Special Purpose Vehicle (SPV).
SPV in Asset Securitization
The lender sells the pool of loans to the SPV. The SPV divides the pool of loans into different risk classes, known as tranches. Each tranche has a different level of risk and return which caters to the diverse appetites of all investors. These tranches are marketed and sold to investors through investment banks. Investors can invest in different tranches based on risk tolerance and their overall objectives.
- Collateral Intermediation : This is a crucial activity of Shadow Banks where the bank helps to facilitate secured transactions and reduce counterparty risks.
Shadow Banking and the 2008 Financial Crisis:
The financial crisis of 2007-2008 was, at the time, the most dreadful economic downturn recorded in the United States since the Great Depression. Before the crisis, the dominant view among policymakers was that only traditional commercial banks could pose any kind of risk to the market. Shadow banks, also known as Non-bank finance companies, were assumed to be less threatening, and that the failure of such firms would pose less risks to the economy.
The 2008 Financial Crisis
However, the crisis clearly showed that nonbank financial firms (shadow banks) pose severe risks to the financial system. Shadow Banks sparked the 2007-2008 crisis by issuing mortgages to borrowers with lower credit ratings, called Subprime Mortgages, packaging them into securities and distributing them in the financial system. This led to the eventual collapse of major financial firms which were involved in shadow banking, such as AIG and Lehman Brothers.
Conclusion
As financial markets continue to evolve, it remains a challenge for regulators to strike the right balance between promoting innovation and safeguarding financial stability in the shadow banking sector. Addressing these challenges effectively is essential for reducing the potential threats that shadow banking can pose to the broader financial system.
References
1. Nath, R. D., & Chowdhury, M. A. F. (2021). Shadow banking: A bibliometric and content analysis. Financial Innovation, 7, Article 86. SpringerOpen. Retrieved from https://jfin-swufe.
2. Pozsar, Z., Adrian, T., Ashcraft, A., & Boesky, H. (2010). Shadow banking (Staff Report No. 458). Federal Reserve Bank of New York. Retrieved from https://www.newyorkfed.org/
3. Lysandrou, P., & Nesvetailova, A. (2014). The role of shadow banking entities in the financial crisis: A disaggregated view. Review of International Political Economy, 22(2), 257–279. Retrieved from https://doi.org/10.1080/
4. Adrian, T., & Ashcraft, A. B. (2012). Shadow banking: A review of the literature (Staff Report No. 580). Federal Reserve Bank of New York. Retrieved from https://www.newyorkfed.org/
5. Sivramkrishna, S., Gune, S., Kandalam, K., & Moharir, A. (2019). Shadow banking in India: Nature, trends, concerns, and policy interventions. Economic and Political Weekly, 54(2), 45–53. Retrieved from https://www.epw.in/journal/