Is Shadow Banking Dangerous for You?

From hedge funds to mortgage-backed securities, unregulated and risky activities have fallen out of favor since the Lehman Brothers debacle. Aggressive, casino-type behaviors and obscure transactions definitely played an important role in the run up to the financial crisis of 2008. But are all financial activities that operate outside the regular banking system bad? Is anything that is lightly regulated or not regulated at all dangerous for the economy and bad for you?

Five years after the beginning of the financial crisis, we need to ask the question and come up with a good answer. “Shadow banking” is defined as credit intermediation involving entities and activities outside the regular banking system. Hedge funds and leasing companies participate in these activities, but so do trust financing companies, pawn shops and individual money lenders in the developing world. And whether they happen in the shadows or in daylight, shadow banking is an important source of funding for the private sector. The problem is that it is also a source of systemic risk.

The most recent Economic Premise, “Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets?” gives us a very good idea of what it is at stake. Authors Swati Ghosh, Ines Gonzalez del Mazo and İnci Ötker-Robe, talk of the need for policy trade-offs “to ensure that shadow banks provide alternative but safe sources of funding to the private sector without generating additional systemic risks.”

While shadow banking in rich economies tends to involve complex and opaque chains of intermediation – as we all saw with mortgage-backed securities – they tend to be simpler in emerging-market and developing economies. Nevertheless, as the Economic Premise authors argue, the risk of shadow banking comes both from its growing importance in the overall financial system and its interconnectedness with regulated activities.

The Financial Stability Board, which coordinates at the international level the work of national financial authorities, estimated the size of the global shadow banking system at about US$60 trillion in 2010  representing 25-30 percent of the total financial system, or about half the assets in the regular banking sector – compared with an estimated US$27 trillion in 2002.

China is a case in point. While subject to significant difficulties of measurement, off-balance sheet and underground lending is estimated to have more than tripled by the end of 2010, from RMB 3 trillion in 2007. Anecdotal information suggests that the share of nonbank loans may have increased from 8.7 percent of total loans in 2002 to as much as 79.7 percent in 2010.

There are growing concerns about the challenges shadow banking could have in the stability of China’s financial system. As the bulk of trust financing, for instance, goes to infrastructure projects and high-return sectors, there’s the risk that a decline in the economy or in asset prices could lead to an increase in defaults.

As a result, the Chinese authorities have undertaken some measures, like plans for increased monitoring and indirect regulation of shadow banking activities, and efforts in Wenzhou to convert underground loan companies into local banks servicing small and medium enterprises.

It’s still too early to say exactly how these measures will turn out. But the way China deals with its own shadow banking system will be of relevance for the rest of the world – especially vis-à-vis better monitoring and supervision, even if indirectly. After all, the rise of shadow banking, here in the U.S. or in an emerging market like China, has been the result of tight controls on the regular banking system.

So to ensure that shadow banks are not dangerous for the economy or for you, we can start by following the recommendations included in Economic Premise. Improved data collection, better cooperation between regulatory agencies of both banking and nonbanking institutions, and expanded capital markets in emerging economies are a good way to begin.

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5 Responses to "Is Shadow Banking Dangerous for You?"

  1. harvey   September 18, 2012 at 8:58 am

    The old adage is still true that "banks only lend money to people who don't need it."

    Forget about China. Moreso today than ever in the USA, only well-established and / or well-connected people can really utilize the "official" banking system. So, naturally, the shadow system of check cashing windows and pawn shops is exploding.

    Our national disgrace is that fully 1/4 of US workers are "un-banked" and rely on the unregulated vagaries of the corner Western Union for their personal finances. This should be a wake-up call that something has gone horribly wrong with the American Dream…

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  4. Laura   June 27, 2013 at 11:47 am

    It is a very interesting and important article, including the original study “Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets?” by Swati Ghosh, Ines Gonzalez del Mazo and İnci Ötker-Robe.
    The distinction of the two kinds of shadow baking is a refreshing approach. On one hand, the one characterized by the casino type behavior and obscure transactions with its own systemic risks. On the other hand, the pawnshops, the micro finance and individual money lenders, which is an important source of finance for the individuals and business that don't have access to the "formal banking system".
    The second well taken point is about the importance, especially for developing countries, of the "informal financial" segment for the development.
    The third interesting point is the incredible growth in the last years of the "informal financial" segment.
    However, there are some issues that I believe could be taken into account in further studies. Some of the suggestions are pointed out below.
    1. Modus Operandi. It is well known that there are significant differences of rationality between the formal shadow banks with casino behavior and the the informal shadow banking composed by the micro finance, individual money lender, among others. The relation between the credit and real sector is much closer in the second one. I had already seen how well the micro finance cooperative work in developing countries such as El Salvador, Honduras and other Latin American countries. In these cases, the default are much lower than the formal banking. The credit is immediately spend buying tools and merchandise by the small business and the final products are sold in a very short time. This modus operandi allows the pay back of the credit, and at the same time it generates real demand, which means increase of production, jobs and income.
    2. Regulation. Part of the informal shadow banking is based on an cooperative style, if one of them does not pay back, all of the other members are responsible for the payment. It means that this system generate some kind of self regulation. The formal shadow banking, on the other hand, is almost impossible to be regulated de facto for many reasons, that were already pointed out by many specialists. Just to remember some of them: the revolving doors, too big to fail, systemic risks, powerful lobby, among others.
    3. Size. Finally, it would be interesting to know the number of credit transactions and its average size in the informal financial segment. My guess is that each one is much smaller than in the formal financial sector shadow or not. If it is proven by other studies, this increasing segment of the financial market will require specific instruments, tools, institutional and legal framework to provide an adequate finance for their increasing demand. It is important to stress that the reason for individuals or business access informal banking is usually they are on the lower level of the income distribution and therefore they don't have access to the formal banking system.
    It seems that those three points are particularly important for multilateral institutions, such as World Bank, to increase its efficacy in alleviating poverty through appropriate credit instruments for the private sector that doesn't have access to the formal financial sector. This is specially relevance for the less developed countries in Latin America and Africa. There are at least two kinds of interventions for the multilateral institutions. One is to support the countries to design the most appropriate institutional framework, considering the increasing numbers of "clients" for the informal financial sector. The second is through specific projects aimed to increase the availability of this kind of credit.