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Banking 24 Feb 2016

Both sides of the shadow banking system

“The shadow banking system” is a term that is becoming increasingly common in the media and talk shows on finance and economics. It gets its name from the expression “shadow banking”, which is used to refer to entities that are not banks engaging in bank-like activities.

What is the shadow banking system? Of the many definitions out there, the one we like the most come from the Financial Stability Board (FSB), an international body that monitors the stability of the global financial system. They define it as, “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. Of the many actors who engage in this type activity, investment funds, asset managers and brokers/dealers stand out.

As reported in FSB’s November 2015 Global Shadow Monitoring Report, the number of entities and activities engaging in shadow banking have been growing since 2010. The report indicates that the shadow banking system represents approximately 80% of the global GDP, and 90% of the global financial system’s assets.* It is worth mentioning that more than 80% of assets owned by the shadow banking system come from developed countries’ economies in North America, Asia and Western Europe. In fact, it states that in the 20 Euro-zone countries, the amount of assets from non-bank entities grew by US$1.6 trillion in 2014 to US$80 trillion. The largest increase was in China.

In other words, we are not talking about a small industry. The need for greater and better regulation of the shadow banking system was even a topic covered by the recent Democratic Party’s campaign in the U.S. The supervisors are obviously aware of this need and have been working on it for the past several years.

In fact, transforming the shadow banking system into a transparent, market-based financing system was one of the four pillars the G20 established for global financial reform in their first meeting in Washington back in 2008. Progress toward achieving this goal, however, is still in the early stages. There is still work to be done.

What has been done so far to reduce the risk of the lack of regulation of this financial activity? BBVA Research indicates that most significant progress has been made in improving transparency. The goal is to have a coherent, harmonized global regulatory framework with the same conditions for all members of the financial system. This would make non-bank financing sources safer and more sustainable for the real economy and reduce the associated systemic risk factors as much as possible.

In a report published in January, BBVA Research named the shadow banking system one of the global regulatory priorities for 2016. It maintains that it does have its benefits, such as helping to create liquidity and market-making activities, as well as diversifying risks (because it makes it possible to transfer some of these risks from the banking sector to other parts of the financial system). It also complements bank credit in financial intermediation and reduces due to less intermediation and more competition.

The report also warns of the risks that come with it. The shadow banking system could become a considerable systemic risk if it is not sufficiently regulated and supervised, like the last financial crisis seems to suggest. It creates uncertainty because it is generally opaque and there are still a lot of unknowns. More importantly, it promotes regulatory arbitrage and reduces market discipline at a time when sustainable growth in the real economy is needed.

 

* These figures include 26 jurisdictions, including Ireland for the first time.

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