Q+A-What is Shadow Banking and Why Does it Matter?

Published February 09, 2012

| Reuters

 The shadow banking system makes up 25 to 30% of the total financial system, according to the Financial Stability Board (FSB), a regulatory task force for the world's group of top 20 economies (G20).

This largely unregulated sector was worth about $60 trillion in 2010, having grown from an estimated $27 trillion in 2002, according to the FSB. While the sector's assets declined during the global financial crisis, they have since returned to their pre-crisis peak.

There are concerns that more business may move into the shadow banking system as regulators seek to bolster the financial system by making bank rules stricter.

Below are some questions and answers about shadow banking.

WHAT IS SHADOW BANKING?

The shadow banking system is made up of financial entities which have the same functions as traditional banks but which are subject to little, if any, regulation.

Like traditional banks, shadow banks provide credit and liquidity but, unlike their traditional counterparts, they do not have access to central bank funding or safety nets like deposit insurance.

Shadow banking includes money market funds, private equity funds, hedge funds, securitisation, securities lenders, and structured investment vehicles. Broad definitions also include investment banks and mortgage brokers.

HOW DO SHADOW BANKS WORK?

Unlike traditional banks, shadow banks do not take deposits. Instead, they rely on short-term funding provided either by asset-backed commercial paper or by the repo market, in which borrowers offer collateral as security against a cash loan and then sell the security to a lender and agree to repurchase it at an agreed time in the future for an agreed price.

Shadow banks, which are often based in tax havens, invest in long-term loans like mortgages, providing credit across the financial system by matching investors and borrowers individually or by becoming part of a chain involving numerous entities, some of which may be mainstream banks.

WHAT ARE THE PROS OF SHADOW BANKING?

The shadow banking system offers credit and also provides liquidity and funding in addition to that provided by the mainstream banking system.

Given the specialised nature of some shadow banks, they can often provide credit more cost-efficiently than traditional banks.

The shadow banking system is very 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 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 might not otherwise have such access.

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 circumvent the strictly regulated mainstream banking system and therefore avoid rules designed to prevent financial crises.

Shadow banks can also cause a buildup of systemic risk indirectly because they are interrelated with the traditional banking system via credit intermediation chains, meaning that problems in this unregulated system can easily spread to the traditional banking system.

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 "runs" on these unregulated institutions. Economist Paul Krugman said a run on shadow banks was "the core of what happened" to bring about the global financial crisis of the late 2000s.

Shadow banks' collateralised funding is also considered a risk because it can lead to high levels of financial leverage.

By transforming the maturity of credit -- such as from long-term to short term -- shadow banks fuelled real estate bubbles in the mid 2000s that helped cause the global financial crisis when they burst.

IS THE SHADOW BANKING SYSTEM REGULATED AT ALL?

In the United States the Dodd-Frank Act, passed in 2010, made provisions which go some way towards regulating the shadow banking system by stipulating that the Federal Reserve would have the power to regulate all institutions of systemic importance, for example.

Other provisions include registration requirements for hedge funds which have assets totalling more than $150 million and a requirement for the bulk of over-the-counter derivatives trades to go through exchanges and clearing houses.

When Mark Carney was appointed chairman of the FSB in November, he said the global watchdog might introduce direct regulation of the shadow banking system to tackle the risks moving into this unregulated sector from the heavily supervised mainstream banking sector.

He said regulating the shadow banking industry would be a top priority for the board in the coming months and signalled that the FSB was likely to implement hard rules for activities like securitisation and money market funds, and use registration requirements to ensure more transparency in others.

The recommendations for G20 leaders on regulating shadow banks are due to be finalised by the end of 2012.

The United States and the European Union are already approving rules to increase regulation of areas like securitisation and money market funds. (Reporting by Michelle Martin; Editing by Giles Elgood)

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