By Jannet Smith 
Introduction
Shadow banking is the other way of conducting financial business which exists parallel to the conventional banking system. This sector comprises companies like hedge funds private equity funds money market funds SIVs and other similar non banking finance houses. offshore banking has expanded tremendously in the last few decades and is now an indispensable cog in the financial wheel.
While it offers the demand for liquidity and credit in the economy it opens great risks given its less standard nature. Providing an understanding of shadow bankings emergence characteristics advantages disadvantages and the issues concerning its regulation.
Historical Background and Evolution
Origins
Shadow banking first appeared in the early part of the twentieth century. Still it became especially widespread in the conditions of the global financial crisis of the late twentieth and early twenty first centuries. To begin with it was not defined as a separate sector it was a pool of all nonbank financial activities.
The term shadow banking is believed to have emerged during the 2008 financial crisis by the economist Paul McCulley who used the term to explain the myriad of nonbank financial institutions that played a key role in the collapse of the financial sector.
Growth and Expansion
Financial Innovation
Towards the end of the twentieth century there was a lot of innovation in the financial industry which saw the creation of instruments such as MBS CDOs and other securities in the financial markets. These innovations paved the way for the further growth of shadow banking activities.
Regulatory Arbitrage
These financial institutions are subjected to strict regulatory standards such as capital standards liquidity standards and reserve standards. Those shadow banking entities which are not bound by these regulations provide another option to investors willing to accept higher risks and less oversight.
Demand for Credit
This has led to the effective rise in shadow banking mainly due to the expansion of credit mainly in real estate and consumer credit. To fulfil this demand nonbank financial institutions have stepped in especially when traditional banks are faced with regulatory burdens.
Globalisation
The liberalisation of capital accounts around the world has enhanced the development of shadow banking. Globalisation of capital and the growing integration of financial firms act as vehicles for shadow banking across borders.
Structure of Shadow Banking
Shadow banking involves different forms of institutions and operations.
Non Bank Financial Institutions
Hedge Funds
These are closed end funds that trade in the stocks using different methods to earn good profits for the investors. Many hedge funds use leveraging which means that their profits and losses are also multiplicated.
Private Equity Funds
These funds get involved with private firms buying large blocks of shares for the express purpose of reviving their performance and then flipping them. Private equity funds are important in the provision of funds for companies that cannot access credit facilities from banks.
Money Market Funds
These are mutual funds that invest in short term high quality debt securities. Despite being ranked as safer than other mutual funds money market funds come with certain risks especially during a crisis.
Structured Investment Vehicles (SIVs)
SIVs are structures that fund long term assets through short term liabilities. They deal in securities such as MBS and CDOs and engage in the use of commercial paper to finance their operations.
Financial Products and Instruments
Mortgage Backed Securities (MBS)
These are securities that a group of mortgage loans under writes. Owners of MBS securities receive periodic payments that are obtained from monthly payments received from homeowners. MBS was also instrumental in the occurrence of the 2008 financial crisis.
Collateralized Debt Obligations (CDOs)
CDOs are securities that incorporate different types of obligations such as mortgages bonds and loans. These pools are then segmented by tranche with associated risks and returns.
Repurchase Agreements (Repos)
Repos refer to short term credit facilities whereby one party will sell a security to another with an understanding that the same security will be bought back at a later date at a higher price. Repos are used to offer money to financial institutions.
Asset Backed Commercial Paper (ABCP)
ABCP means asset backed commercial paper which is a short term paper sold to investors that is floated by a special purpose vehicle and that is secured by several forms of assets including receivables or mortgages. ABCP is employed to fund SIVs and other non bank financial companies activities.
Benefits of Shadow Banking
Increased Liquidity
They are involved in funding within the financial market for the shadow banking entities. They assist in putting the right geographical disparity by availing facilities where needed since that is where resources are supposed to be available.
It may stabilise the financial markets as well as foster the emergence of such markets in certain emergent economies.
Credit Provision
Loans and credits given by shadow banking institutions can reach sectors and borrowers others cannot reach. This entails Micro Small and Medium Enterprises emerging companies and other new budding or solo business entities with restricted access to conventional financing.
Diversification
Such a scheme allows customers to extend their opportunities to use financial products and services provided by SB entities thus reducing the possible risks and increasing financial stability.
Innovation
This is because a shadow banking system has less regulation than the traditional banking sector and therefore helps in the development of new products. Mainly new forms of financial products and investment methods are first of all released and implemented in the Shadow Banking System.
Efficiency
Shadow banking institutions are generally less expensive and more effective in terms of the conventional banking sector. This could lead to a low cost of capital or funds and high returns on investments for those who stake in the firm.
Market Completeness
In other words they are all able to form another layer of the banking system and make the financial market more competitive. SIBs undertake activities such as securitization and maturity transformation which might be restricted in the case of traditional banks. The following are some of the risks in the shadow banking system
Lack of Regulation
The other danger that can be linked to shadow banking is the lack of regulation. Some shadow banking entities operate below legal standards which makes them carry out many risks and become unproductive.
Opacity
Another difference is that shadow banking companies have fewer disclosures of operational and financial performances compared to traditional banking entities. This lack of transparency can hide the level of risk in the financial system this makes it difficult to figure out and manage risks both for the regulators and market participants.
Leverage
In essence credit and leverage constitute one of the key pillars of many shadow banking entities as they seek to magnify returns. This can be advantageous during prosperous times but it also results in the increase of substantial risks during poor periods and can cause instabilities within the business.
Interconnected
SMEs in the shadow banking sector have business relationships with formal banking systems as well as other firms and organisations as shown through financial transactions and contracts. It also defines interconnectedness which makes for systemic risk due to the fact that troubles affecting shadow banking will affect the overall financial system.
Liquidity
Mismatch Maturity transformation is the most evident and risky practice where shadow banking entities borrow in the short term but lend in the long term. This results in a liquidity gap that can result in adverse outcomes when access to short term funds becomes difficult as was witnessed in the events that preceded the 2008 financial meltdown. Market Runs Not a surprise shadow banking entities can experience runs where investors seek to withdraw their money swiftly much like in the case of traditional banking.
However unlike conventional commercial banks shadow banking entities cannot go to the central bank for support or avail the benefits of deposit insurance thus they are far more susceptible to a liquidation crisis.
Case Study
The global financial crisis witnessed in the 2008 period exposed both risks and fragilities that are inherent in shadow banking. Several key factors contributed to the crisis
Securitization and Mortgage Backed Securities (MBS)
Subprime mortgage lending became securitized and turned into new tools like MBS and CDO by cutting up risky debts into slices. These instruments were popular with the so called shadow banking institutions which took a huge bath when the housing market soured.
Leverage and Liquidity
Most shadow banking entities especially hedge funds and SIVs had a high level of leverage and in most instances had short term funding. These entities suffered from acute liquidity crunch when the market in asset backed commercial paper [ABCP) Shut down abruptly.
Interconnectedness
Related to this issue the financial system embraced the interconnectivity of different entities which raised the concern that issues in the shadow banking sector escalated to massive problems affecting conventional banks and other financial institutions. Large money borrowers in the banking sector were found to have indulged in a number of transactions including lending to shadow banking entities.
Lack of Transparency
Some of these activities operated outside the regulatory radar and hence the true scale of shadow banking remains obscure to regulators and the participants in the market. This lack of transparency played its part in fanning unfair panic and discouraging the confidence necessary to surmount the crisis.
This eventually led to a number of regulation alterations that were envisioned to address the aspects of shadow banking. Some of these reforms include the following A higher level of transparency Better capital and credit creation for banks
Standardisation of risk management
Ambiguity
It could be the reason why its scopes are difficult to define and put into a narrow and extensive regulation box of shadow banking.
Jurisdictional Issues
Shadow banking entities can naturally go across borders so they are a nightmare for regulators. It is possible only for some jurisdictions to have a different regulation from others which allows firms to practise regulatory arbitrage.
Innovation and Adaptation
Shadow Banking is a concept that concerns an endless appearance of new products and activities which is a characteristic of financial innovation. As such the volatility of such changes calls for enhanced ongoing adjustments by the regulators which could be costly and time consuming.
Data Gaps
In light of this there are significant gaps in data mostly because some aspects of shadow banking are complex and concealed. From another perspective the regulators may need more information that can assist in the assessment of risk within the industry.
Regulatory Responses
Enhanced Oversight
All jurisdictions have extended this regulatory oversight to shadow banking activities and firms. This amounts to complicated reporting regimes and improved monitoring of the developing sources of systemic threats.
Capital and Liquidity
Some regulators have also targeted principal and liability management at particular shadow banking institutions with a view of enhancing the stability of such institutions and reducing systemic risk. For instance the liquidity requirement of the money market funds in the United States is now tighter.
Transparency and Disclosure
There have been efforts made towards the increase of transparency and disclosure in matters concerning shadow banking. This involves additional disclosure on matters such as the off balance sheet entries and more information about these risks.
Macroprudential Policies
Macroprudential policies are supposed to be used to address risks inherent in the financial sector. These include provisions in the form of counter cyclical capital buffers as well as loss revelation for shadow banking institutions through stress testing.
International Coordination
Given the global dimension of China’s shadow banking system this is the most important approach. There are agencies such as FSB and IMF that help promote cooperation with countries across the world and help deal with differences.
Shadow Banking and Its Future
Several trends and developments will shape the future of shadow banking. The future of shadow banking will be shaped by several trends and developments
Technological Advancements
Fintech and blockchain are some of the dominant forms of innovation that are disrupting the financial markets. Such developments shift the nature of shadow banking operations and change possible regulations.
Regulatory Evolution
As and when the regulators develop strategies to cope with the rapid changes in the financial services industry the legal framework for shadow banking is bound to go through corresponding changes. This may involve changing laws in an effort to come up with new ways of handling newly emerged risks and appropriate implementation of the existing laws.
Market Dynamics
Market forces and conditions that define shadow banking undertakings shall also affect their operations and progression. Other aspects that influence future conditions include interest rates economic growth and market volatility in this sector.
Sustainability and ESG
While assessing operations and investment decisions financial business organisations are placing much emphasis on ESG factors. Some shadow banking entities may experience pressures to achieve sustainable solutions and such ESG factors in their investments.
Risk Management
Enhancing risk management practices will be critical to dealing with future risks in shadow banking. This has enhanced stress testing risk analysis and improved contingency planning among other things.
Growth in Emerging Markets
Shadow banking has expanded steadily across emerging economies to meet the credit demands and financial services that are not provided by the formal banking system. In these regions shadow banking completes important missing links in the overall offer of the financial market which essentially targets individuals and companies who are adequately served by the formal sector.
Drivers of Growth
Financial Inclusion
At the same time formal banking penetration in most of the emerging markets is still low and only a limited number of people have access to banking services. Innovative non bank institutions including microfinance organisations P2P lenders and mobile money operators play an essential role in delivering access to those excluded populations.
Such services consist of microcredit facilities savings and remittance among them popular services that are significant for development and poverty reduction.
Regulatory Arbitrage
Knights and Theopolis note that developing economies have comparatively more relaxed financial governance systems than their counterparts in the developed world. This lack of regulation implies the existence of a formidable loophole whereby new shadow banking entities are able to provide innovative financial products and services that have minimal compliance requirements compared to banks.
Technological Innovation
The penetration of technology within emerging markets has been rapid in accelerating the development of shadow banking. Advances in mobile banking fintech platforms and blockchain technology have led to the provision of banking services to reach out to remote and less served people. These technologies lower transaction costs and make the process easily accessible hence fueling shadow banking.
Economic Growth
Emerging markets for instance have enjoyed high economic growth rates and this has in turn put pressure towards credit demands. Official financial institutions have allowed shadow banking entities to do what is needed to support capital requirements for businesses and consumers and establish further economic growth. This is especially true in such sub activities as real estate easily accessible credits and microbusiness loans.
Benefits in Emerging Markets
Access to Credit
It contributes to improved access to credit in EMs through the shadow banking sector. In addition to this argument shadow banking includes giving out loans to individuals and small businesses that might be deemed high risk by conventional banks hence spotting talent entrepreneurship and improving the economy.
Innovation and Competition
It is argued that having shadow banks means there is competition within the financial systems and this will prompt traditional financial institutions to enhance their operations. Thus it can result in improved financial products a decline in costs and a competitive enhancement of customer services.
Financial Resilience
Shadow banking can help improve the stability of the overall structure of the emerging markets financial assets by expanding the sources of credit and financial services. The more diverse financial structures are immune or can work well and sustainably during economic shocks.
Risks in Emerging Markets
Regulatory Gaps
A general weakness of financial regulation in EMs is possible which causes excessive risk taking and financial fragility in the shadow banking system. These entities may end up participating in risky activities which are a threat to the stability of the larger financial system if not closely monitored.
Consumer Protection
To date consumer protection laws still need to be developed or implemented in most emerging markets. This can put borrowers in a fairly precarious position in terms of exposure to predatory practices and financial abuse at the hands of shadow banking institutions.
Systemic Risk
Thus the fast development of shadow banking can lead to systemic risks and this is more notable when the shadow banks are linked closely with conventional banking systems in emerging markets. A problem within the shadow banking industry could easily spill over into the rest of the financial structure as demonstrated by the IMFs GFC.
The heading Regulatory strategies for emerging markets is quite suitable since it contains two important parts Regulatory and Emerging markets.
To mitigate the risks associated with shadow banking while harnessing its benefits regulators in emerging markets need to adopt targeted strategies To mitigate the risks associated with shadow banking while harnessing its benefits regulators in emerging markets need to adopt targeted strategies
Enhanced Oversight
Essentially creating a sound regulatory model for touch and shadow banking activities is imperative. This requires establishing measures such as capital regulation risk management and disclosure.
Consumer Protection
Preserving consumers rights and guaranteeing that legislation is implemented can protect borrowers from anti competitive actions. It will then also enlighten consumers so that they can make good financial decisions if education and awareness programs are available.
Data Collection and Analysis
Knowledge of shadow banking still needs to be improved mainly due to a lack of comprehensive and accurate data on such activities therefore increasing the efficiency of data collection and analysis might contribute to assessing the growing risks. These include the need for investment in particular technology and cooperation affiliation with international governing organisations.
Collaboration with Traditional Banks
Promoting partnerships between ordinary banking institutions and individuals who operate within the shadow banking sector can help FRAs achieve their goal of expanding access to finance while also ensuring greater stability of the financial system. Mechanisms can utilise great assets in areas of concern such as helping the sector offer integral monetary products.
Conclusion
As a financial phenomenon that has become a focus of academic and political discussion shadow banking is a highly diverse and very significant part of the financial system. On the one hand it comprises the necessary liquidity credit and financial creation on the other hand having a less regulated environment it encompasses robust risks.
This was seen during the 2008 financial crisis in countries such as the US where shadow banking weaknesses were revealed and provoked tighter new regulations in an effort to improve the safety and stability of these institutions and reduce overall systemic dangers. In the future they shall remain vigilant to the new methods and trends in the operation of the financial markets and the global economy.
To achieve this one will have to strike a fine beam between liberalising shadow banking operations so as to provide adequate space for the creation of good innovations. The creation of efficiency as well as putting in place adequate measures to mitigate the risks involved in shadow banking.
Concerns that are associated with shadow banking can be addressed through increased supervision augmentation of accountability and increased cooperation with international partners in a bid to reap the advantages aimed by this sector.