Dubai: The term ’shadow banking system‘ was first used in 2007, and gained popularity during and after the recent financial crisis, as it highlighted the bank-like functions performed by entities outside the regular banking system.
The more comprehensive definition, as adopted by the Financial Stability Board (FSB), i.e., ‘credit intermediation involving entities and activities (fully or partially) outside the regular banking system’ has been globally accepted.
Shadow banks comprise entities which conduct financial intermediation directly, such as finance companies or NBFCs, and entities which provide finance to such entities, such as mutual funds. Globally, shadow banking entities could be covered under the broad heads of money market funds, credit investment funds, hedge funds, finance companies accepting deposits or deposit like funding, securities brokers dependent on wholesale funding, credit insurers, financial guarantee providers and securitisation vehicles.
Such nonbank intermediation, when appropriately conducted, provides a valuable alternative to bank funding and supports real economic activity. But experience from the financial crisis demonstrates the capacity of some non-bank entities and transactions to operate on a significantly large scale, in ways that create bank-like risks to financial stability.
Like banks, a leveraged and maturity-transforming shadow banking system can also be vulnerable to “runs” and generate contagion, thereby amplifying systemic risk. Shadow banking can also heighten pro-cyclicality by accelerating credit supply and asset price increases during upswings and exacerbating fall in asset prices during downswings.
Traditionally, regulation of banks has assumed greater importance than that of their non-banking counterparts. One reason, of course, is that protection of depositors. Banks are at the centre of payment and settlement systems and monetary policy transmission takes place through them. Banks play a critical role in credit intermediation through maturity transformation, i.e. acceptance of short term liabilities and converting them into long term assets through loans and advances.
Along with economic value, this function also creates potential liquidity risk. Moreover, banks also operate on a significantly higher leverage compared to non-financial entities which could amplify their vulnerability. For all these reasons, banks are subject to a detailed and a rigorous regulatory framework. However, when non bank financial entities, which are subject to no regulation or light touch regulation, undertake bank-like functions, large risks are created which could potentially be destabilising for the entire system.
— With inputs from Address by Anand Sinha, Deputy Governor, Reserve Bank of India
