Banking is perhaps the most regulated industry on the planet. The movement of funds in and out of the banking system is monitored by governments as well as regulators. However, competitive pressures force banks to undertake more risks and if possible earn a higher rate on their investments. This is what creates a parallel financial universe called the shadow banks.

Many experts believe that attempts to regulate banking are nothing except a self-defeating pursuit. This is because the shadow banking system provides a free pass to the banks to circumvent any regulation. The shadow banking system is said to grow and diminish in size. However, it never vanishes. Shadow banking has survived the scrutiny and crackdown that came their way post the catastrophic collapse in 2008.

What are Shadow Banks ?

To understand shadow banks, we must first understand banking. Banks accept deposits and give out loans.

In other words, banks accept short term liabilities and give out longer term loans. This activity of borrowing short term and lending long term can also be replicated in the money markets.

Therefore, if a company were to set up a money market fund and sell short term securities and use the proceeds to make long term loans, they would effectively be conducting banking. The only thing missing would be a bank license.

Since there is no bank license, there would also not be any regulation. There would be no reserve ratios or capital ratios to maintain and therefore no need to borrow from interbank markets. The shadow banks will be able to perform every function of banking except accept deposits from the public. Since most of the shadow banks have no interest in accepting deposits anyways, the arrangement works perfectly fine.

The Three Functions of Shadow Banks

The three defining functions that must be performed by any institution in order to be called a shadow bank are as follows:

• The shadow bank must issue short term securities and use the proceeds to buy longer term assets. Now the question arises as to why would lenders buy short term risky securities of an unknown corporation? Well they do not have to. A lot of these shadow banks are implicitly or explicitly backed by commercial banks and therefore command the sort of confidence that is required to sell securities in the government markets.

• The shadow banking institution must be have liabilities which are liquid and assets which are relatively illiquid

• The shadow bank must use further leverage while making investments. These investments can be made by raising money from other institutions.

Advantages of Shadow Banking System

• No regulation: There is only one huge advantage to having the shadow banking system i.e. no regulation. Since the banking industry is so regulated, this advantage is big enough to offset hundreds of disadvantages on its own.

  No regulation on the money raised by selling securities allows the shadow banks to take as much risk as they would like to without defaulting on their obligations. Compliance procedures and reports which cost millions of dollars as well as disruption of operations are no longer required.

Disadvantages of Shadow Banking System

• No Access to Cash:

  Shadow banks are not backed by the central bank. As a result, they do not have any kind of backup that would save them from trouble if the depositors suddenly wanted to withdraw their cash. It is true that commercial banks indirectly back these shadow banking institutions. However, it is difficult for them to divert cash towards their shadowy arm especially if a crisis is in progress. This creates a situation wherein shadow banks not only face huge risks themselves but also pose systemic risk. This is because their business creates the same amount of risk as that of banks. However, they do not have the preventive regulations or the safety nets that banks have access to in case things start going wrong.

• Distressed Sale:

  Shadow banks buy long term assets and finance them by selling short term securities. However, if investors become wary about a bank’s health, these long term assets have to be liquidates with immediate effect. This creates a situation of distressed sales.

  Firstly, the shadow bank itself has to book losses on these distressed sales. Secondly, the assets start trading at a lower market value due to the sudden increase in supply. Therefore, other banks which are holding such assets also have to mark down their balance sheet. This creates a downward spiral wherein perceived losses create actual losses. This is why shadow banks are said to pose “systemic risk” to the actual banking system. However, the allure of no regulation is so strong that these banks have not been eradicated from the system till now.

• Salvage Reputation:

  The 2008 meltdown exposed a lot of links between the commercial banking system and the shadow banking system. This is because when these shadowy banks started going bust, they were often bailed out by commercial banks. Commercial banks would do so in order to maintain their reputation in the money market so that they can continue their operations in the future.

  However, as a result of the 2008 expose, very few banks are now willing to indulge in shadow banking. Any bank seen as having exposure to shadow banks, immediately witnesses a drop in its share prices as well as large cash withdrawals. However this phase is only temporary and has happened multiple times before. Shadow banking system seems to expand and contract, however as mentioned above, it does not vanish!