Shadow Banking

A shadow banking system can be broadly defined as the system of credit intermediation that involves entities and activities outside the regular banking system. Non-bank financing provides a valuable alternative to bank funding and helps support real economic activity. It is also a welcome source of diversification of credit supply from the banking system, and provides healthy competition for banks.

This article will provide information about the concept of shadow banking in the context of the IAS Exam.

This article is useful for the GS Paper III (Banking concepts) of the UPSC Syllabus.

The candidates can read more relevant information from the links provided below:

Introduction

• In 2007, at the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming, the term “Shadow Bank” was coined by the economist Paul McCulley.
• Leading up to the global financial crisis, one of the many failings of the financial system was symbolized by shadow banking.
• Short-term funds in the money markets are borrowed by shadow banks, and those funds are used to buy assets with longer-term maturities.
• Mortgage companies, investment banks, markets for repurchase agreements, money market funds, asset-backed commercial paper [ABCP] conduits, and securitization vehicles are examples of important components of the shadow banking system.
• The meaning and scope of shadow banking is disputed in academic literature.
• Credit insurance providers, securities broker-dealers, private equity funds, credit hedge funds, exchange-traded funds, credit investment funds, structured investment vehicles (SIV), and hedge funds are some of the entities included in shadow banking.
• Shadow banks first attracted the attention of different experts due to their increasing participation in converting home mortgages into securities.
• A broader definition of shadow banks was developed by the Financial Stability Board (FSB). This is an organization of supervisory and financial authorities from international financial institutions and major economies. This included all entities which performed core banking functions, and which were outside the regulated banking system.

Shadow Banking in India

• Compared to the counterparts in advanced economies, the shadow banking sector in India is still small in size.
• The assets of the bank were 86 per cent of GDP, whereas the assets of the shadow banking system accounted for 21 per cent of GDP. These numbers were as per the data provided by the Reserve Bank of India (RBI) in 2011.
• The activities carried out by these entities are limited, apart from the fact that the sector is not significant in terms of size.
• Many of the activities which contributed to the global crisis are either, if allowed, functions in a regulated environment with appropriate limits, or many of those activities are not allowed.
• Complex and synthetic derivative products which were at the core of the global crisis are also not presently permitted in India.
• Transferring of risk off-balance sheet by banks by using SIVs/ conduits is not a model adopted in India.
• Hedge Funds are not significant players in India.

Benefits of Shadow Banking –

• Prompt provision of services, customer orientation, quick decision-making ability, lowering transaction costs of their operations are the main advantages of shadow banks.
• Shadow banking activities constitute a very useful part of the financial system.
• Shadow banking does not mean it is sinister and dark.
• For example, Non-Banking Finance Companies (NBFCs) which are part of shadow banking play a crucial role in the diversification of the financial sector, enhancing competition, and broadening access to financial services.

Shadow Banking – Risks

• Due to their interconnectedness with the banking system, cross-jurisdictional nature, due to their complexities, shadow banks can create risks that can assume a systemic dimension.
• The four types of risks which emanate from shadow banking are contagion risks, regulatory arbitrage, leverage risk, liquidity risk.

Shadow Banking [UPSC Notes]:-Download PDF Here

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