Shadow Banking - Meaning, Functions, Advantages & Disadvantages
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:
Advantages of Shadow Banking System
Disadvantages of Shadow Banking System
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