International Finance
Banking and Finance Magazine

Shadow Banking: Threat to global economy

IFM_ Shadow Banking
Shadow banking has rapidly grown in many other emerging economies where small businesses remain unbanked

The phrase ‘shadow banking’ refers to banking-like operations (mostly lending) that take place outside of the mainstream banking industry. It is now frequently referred to as market-based finance or non-bank financial intermediation internationally. Similar to traditional bank lending, shadow bank lending serves a similar purpose. However, it is not subject to the same regulations as traditional bank lending. The entities that engage in shadow banking are Bond Funds, Money Market Funds, Finance Companies and Special Purpose Entities.

Shadow banking is considered one of the major flaws in the financial system that contributed to the global financial crisis. Paul McCulley, an economist, first used the phrase “shadow bank” in a 2007 lecture at the annual financial conference held in Jackson Hole, Wyoming by the Kansas City Federal Reserve Bank. In Paul McCulley’s talks, shadow banking had a distinctly US focus and referred mainly to nonbank financial institutions that engaged in what economists call maturity transformation. Traditional banks engage in maturity transformation when they use deposits, which are normally short-term, to fund loans that are longer-term. Shadow banks do something similar. In the money markets, they raise (or, more often, borrow) short-term funds that they have and then utilize them to purchase assets with longer-term maturities. However, because they are not subject to regular bank supervision, they cannot borrow money from the Federal Reserve (the US central bank) in an emergency, unlike banks, and they do not have conventional depositors whose funds are insured, therefore they are considered to be in the “shadows.”

How does shadow banking work?

In the traditional lending model, a bank’s ability to lend depends on how much money it can borrow from the market and how much money it gets in deposits. The same principles apply to shadow banking as well. An investment fund, for instance, receives funding from investors and issues shares of the fund in exchange. The investment fund utilizes this money to purchase securities in an effort to generate a return on investment for its investors (for example, a bond issued by a country or company).

The investment fund acts as the channel linking investors and countries/companies to earn an investment return, just as the bank acts as the ‘middleman’ between savers and borrowers to earn a specified interest rate. Shadow banking firms act like banks by obtaining funding from investors and then lending this money to nations or businesses.

Many experts were initially drawn to shadow banks due to their increasingly important role in turning home mortgages into securities. The “securitization chain” began with the issuance of a mortgage, which was later purchased and sold by one or more financial institutions before becoming a part of a group of mortgage loans that served as the collateral for a security that was sold to investors. A mortgage-backed security’s value was linked to the value of the mortgage loans included in the package, and its income was funded by the interest and principal payments that the borrowers made on their own mortgage loans. From the mortgage’s inception to the sale of the security, almost all steps were completed out of regulators’ direct line of sight.

A group of financial and supervisory authorities from major economies and international financial institutions known as the Financial Stability Board (FSB) developed a broader definition of shadow banks that encompasses all entities outside the regulated banking system that carry out the core banking function, credit intermediation (that is, taking money from savers and lending it to borrowers). The four main facets of intermediary are as follows: maturity transformation which means obtaining short-term funds to invest in longer-term assets; liquidity transformation, a concept similar to maturity transformation that entails using cash-like liabilities to buy harder-to-sell assets such as loans; leverage which means employing techniques such as borrowing money to buy fixed assets to magnify the potential gains (or losses) on an investment; credit risk transfer which means taking the risk of a borrower’s default and transferring it from the originator of the loan (or the issuer of a bond) to another party.

By this definition, broker-dealers that use repurchase agreements to fund their assets would be considered shadow banks. In a repurchase agreement, an organisation that needs money sells a security to raise the cash and then promises to buy the asset back at a set price and on a set date to pay back the borrowed money.

Shadow banks are money market mutual funds that aggregate investor money to buy commercial paper (business IOUs) or mortgage-backed securities. Financial institutions that sell commercial paper (or other short-term obligations) and use the proceeds to provide loans to households are also included in this category. These intermediation services are currently being performed by a wide variety of businesses, and they are continuously expanding.

What oversight is there of shadow banking?

The majority of the shadow banking system in the EU is heavily regulated. Resident money market funds, investment funds, and finance businesses are subject to regulation in Ireland. Irish-resident special purpose entities are not regulated by the Central Bank as a sector, as is the case in other jurisdictions. However, compared to other jurisdictions, the Central Bank enforces more stringent reporting requirements on special-purpose corporations, which makes it easier to keep an eye on shadow banking activity.

Experts say, mainly because they obscure the shapes and sizes of objects within them, shadow banking can be frightful. Due to the fact that many of the shadow banking system’s companies do not file reports with government regulators, estimating its size is extremely challenging. The shadow banking system looked to be most prevalent in the United States in the years leading up to the global financial crisis, although nonbank credit intermediation existed in other nations and is still expanding, especially in China. Since 2011, the FSB has examined all nonbank credit intermediation as part of a “global” monitoring operation.

The G20’s 20 largest advanced and emerging market economies have mandated the exercise, which now includes the European region and 28 other countries. The first findings were unreliable since they included “other financial institutions” as a catch-all category, but today the FSB now looks at shadow banks by ‘function’ rather than an entity. Using the entity-based approach, the most recent report (data from the end of 2015) reveals that the US shadow banking system has decreased from 33% to 28%, making the euro area shadow banking system the largest globally at 33% of the total, up from 32% in 2011. The global shadow system peaked at $62 trillion, across the jurisdictions contributing to the FSB exercise in 2007. It dropped to $59 trillion during the crisis, then increased to $92 trillion by the end of 2015. According to the ‘functional’ category, which includes only 27 jurisdictions, asset-management-related operations account for about 22% of the $34.2 trillion in total shadow banking.

Although the FSB’s decision to focus on activities (rather than institutions) rather than institutions brings the measurement of risks closer, it is still insufficient to accurately assess the hazards that shadow banking poses to the financial system. Additionally, the FSB does not assess the amount of debt used to buy assets (often referred to as leverage), the system’s capacity to amplify issues, or the pathways by which issues spread from one industry to another (although there has been some attempt to gauge these latter linkages using balance sheet data between nonbanks and banks).

Over time, it has become clear that shadow banking in several countries is replacing banks’ function as credit intermediaries. Although it is still unclear what the underlying dangers are associated with these behaviours and whether they are systemically significant, we are getting better at tracking their scale.

What are the advantages/disadvantages of shadow banking?

Shadow banking has the benefit of reducing reliance on traditional banks as a source of financing. This is advantageous for the economy since it diversifies the financial system and serves as an extra source of lending. On the other hand, there is a chance that excessive lending in the economy could be a result of shadow banking. This has the potential to lead to a harmful downturn.

How big is the shadow banking system in Ireland?

Over €2.3 trillion in assets were thought to be held by the shadow banking sector functioning in Ireland as of the end of 2017. This makes the majority of investment funds, money market funds, and special purpose entities. They possess non-Irish assets and primarily represent foreign investors. This means links to the home economy are weak.

China’s message of shadow banking to the world

Considered the greatest economy in the world, China has also seen the danger of uncontrolled shadow banking. Following the global financial crisis, the Chinese government encouraged economic growth by providing easy lending and fiscal stimulus, much of which was distributed to the economy by shadow banks that were frequently linked to traditional banks. In 2019, the non-bank sector made up 8% of the nation’s financial industry, by 2016, it had increased to a third of it. The Chinese government covertly supported this trend, and in some cases actively promoted it.

“Shadow banking expanded rapidly based on a combination of regulatory arbitrage by banks trying to channel credit to restricted sectors, along with a widespread perception that government guarantees at some level, central or local, would ultimately backstop any losses,” says Logan Wright, Director of China Markets Research at Rhodium Group, a research firm.

While many inexperienced retail investors were entering the local stock market, problematic loans were steadily burdening Chinese financial systems with dangerously high levels of credit risk as the system developed leverage. Its crash in 2015, which caused major shares to lose up to a third of their value within a month, convinced the authorities that the non-bank sector’s growth posed a threat to financial stability. In response, regulators implemented reforms that mostly involved limiting the interest rates that shadow banks might charge in order to limit their ability to lend. As a result, from 2017 to 2020, the country’s shadow banking assets shrank by RMB11.5 trillion ($1.6 trillion), falling from over 100% of GDP to roughly 80%.

According to Logan Wright, the changes had undesirable side effects even if they were successful in shrinking the sector and lowering liability risks. As additional defaults happened as a result of numerous institutions being cut off from financing, credit risk increased significantly on the asset side of the balance sheet. The crackdown effectively undid the financial system’s deepening, which had benefited underserved borrowers including lower-income people, while undercutting the government’s strategy to create the ‘shared prosperity’ development model, which is intended to promote more equal growth. Although their reliance on shadow banks increased during the COVID pandemic, SMEs, which banks have historically avoided in favour of lending to huge state-run businesses, were particularly hard impacted.

Real estate is another industry that has been severely impacted because some of the main users of shadow banking channels are property developers. The industry, which contributes up to 30% of the nation’s GDP, is currently experiencing a severe crisis, putting some of China’s major property developers at risk of going bankrupt.

“The deleveraging campaign contributed to the property market crisis by encouraging property developers to rely more heavily on pre-construction sales as a primary mode of financing,” says Logan Wright, adding, “Presales effectively became a substitute form of credit for shadow financing channels, which were contracting under the deleveraging campaign. This process also produced a significant expansion of housing supply and new construction at a time when fundamental demand among owner-occupiers was slowing.”

Falling real estate sales are increasingly affecting the banking industry and putting many non-bank businesses’ ability to stay afloat to the test. According to data provided by ‘Use Trust’, Chinese trusts missed payments on financial products with real estate connections totalling almost $9 billion in the second half of 2022.

According to University of Tennessee professor Sara Hsu, an authority on China’s shadow banking sector, one potential reaction would be to further expand the nation’s bond and stock markets.

Sara Hsu said, “The Chinese shadow banking system underscores the need to provide finance to SMEs and early regulation, as well as the need for market-based solutions, even though the West doesn’t have an exact analogue to China’s shadow banking system.”

Shadow banking across the world

In many other emerging economies with unbanked small businesses, shadow banking has risen quickly. An example of this is Mexico, where the tiny size of the banking industry and the low level of trust in SMEs have increased their desire for other finance sources. The credit provider AlphaCredit defaulted first, followed by Credito Real and Unifin, as the boom broke in 2022. Many other non-banks have since been affected by the contagion, and they are now financing themselves with ever-higher interest rates. In total, the three insolvent businesses loaned nearly $6 billion, in addition to releasing about $4 billion in unsecured bonds and debt to international banks. As hundreds of smaller businesses fear running out of financing, the crisis has spread to the actual economy.

Victor Herrera, Partner at Miranda Ratings Advisory, a Mexican financial services firm, and former CEO of S&P Global Ratings in Mexico, said, “Contagion has already set in, and it is very difficult for all remaining players to obtain funding and refinance maturities.”

The economy of the nation is impacted more broadly by default on shadow bank bonds. “Normal Chapter 11 procedures have not been followed and bondholders feel they have been mistreated because of Mexican debt restructuring practices,” Victor Herrera said, adding, “All bond issuers in Mexico, regardless of the sector they are in, will suffer the reputational effect.”

The overarching problem, according to Victor Herrera, is the lack of regulation and supervision. “One questions why a $100 deposit in the bank benefits from ample regulatory supervision, but if a doctor or teacher buys a $100 bond, no government body monitors the risk the retail investor is undertaking, many times without knowing it,” he added.

The crisis ahead

Many analysts worry that authorities may soon discover they have even less control and comprehension of the non-bank financial sector than they anticipated as gloomy clouds gather over the global financial system. The amount of the correction is impossible to forecast because “shadows” do not promote openness, according to Copsey from ABL Business. Increased borrowing costs may have caused asset valuations to become overvalued, which could cause problems with liquidity or possibly insolvency. The financial sector is also facing issues from the oil crisis and the conflict in Ukraine, but complexity is likely the largest problem. According to McMahon of Parallel Wealth Management, “We just don’t know what the trigger event will be.”

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