The shadow banking system is a term for the collection of non-bank financial intermediaries (NBFIs) that provide services similar to traditional commercial banks but outside normal banking regulations. Examples of NBFIs include hedge funds, insurance firms, pawn shops, cashier’s check issuers, check cashing locations, payday lending, currency exchanges, and microloan organizations. The phrase “shadow banking” is regarded by some as pejorative, and the term “market-based finance” has been proposed as an alternative.
The shadow banking system is a group of financial intermediaries which facilitate the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. These companies are often known as nonbank financial companies (NBFCs). The shadow banking system also refers to unregulated activities by regulated institutions.
Globally, shadow banking entities could be covered under the broad heads of:
(i) Money Market Funds
(ii) Credit investment Funds, Hedge Funds, etc.
(iii) Finance Companies accepting deposits or deposit like funding.
(iv) Securities brokers dependent on wholesale funding.
(v) Credit insurers, financial guarantee providers.
(vi) Securitisation vehicles
Like banks, a leveraged and maturity-transforming shadow banking system can also be vulnerable to “runs” and generate contagion, thereby amplifying systemic risk. Shadow banking can also heighten procyclicality by accelerating credit supply and asset price increases during upswings and exacerbating fall in asset prices during downswings. These effects were powerfully revealed during the global financial crisis in the form of dislocation of asset-backed commercial paper (ABCP) markets, the failure of an originate-to-distribute model employing structured investment vehicles (SIVs) and conduits, “runs” on MMFs and a sudden reappraisal of the terms on which securities lending and repos were conducted.
The Importance and Benefits of shadow banking
Shadows do not necessarily mean dark and sinister. In fact, shadow banking activities constitute a very useful part of the financial system. The main advantages of shadow banks lie in their ability to lower transaction costs of their operations, their quick decision-making ability, and customer orientation and prompt provision of services. In India, we have always maintained that Non-Banking Finance Companies (NBFCs), a significant segment of shadow banking system, play a crucial role in broadening access to financial services, and enhancing competition and diversification of the financial sector. While NBFCs are, sometimes, seen as akin to banks in terms of the products and services offered, this comparison is strictly not accurate, as more often NBFCs play a range of roles that complement banks. They have carved out niche areas of businesses, such as auto financing, which enables them to address specific needs of the people more efficiently.
In addition to complementing banks, NBFCs add to economic strength to the extent they enhance the resilience of the financial system to economic shocks. They can act as backup financial institutions should the primary form of intermediation come under stress, thereby constituting an important avenue for risk diversification away from the banking system. Other non-banking finance entities such as mutual funds, insurance companies, etc, provide alternatives to bank deposits and constitute alternative funding for the real economy, which is particularly useful when traditional banking or market channels become temporarily impaired.