Shadow Banking

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It's larger than the world economy. It poses risks to financial stability. And its name conveys a sense of murkiness. “Shadow banking” is a catchall phrase that encompasses risky investment products, pawnshop and loan-shark operations and so-called peer-to-peer lending between individuals and businesses. Even art dealers like Sotheby’s have become shadow banks, making millions of dollars of loans to clients buying masterpieces. The common denominator is that these products and practices flourish outside the regular banking system and often beyond the reach of regulators. The most devastating runs of the 2008 financial crisis were not on bank deposits — as happened during the Great Depression — but on shadow banks such as Lehman Brothers (a broker-dealer) and money-market funds. Shadow banking proliferates for a reason: Free from the shackles of regulation, it gets money to where it's needed. The trick is controlling the dangers. 

The Situation

Global shadow banking assets continue to surge, propelled by investors eager for higher returns in a low interest rate world and companies and local governments desperate for loans. The Financial Stability Board says shadow banking assets that pose risks to the financial system grew 7.6 percent to $45 trillion in 2016. (Total global financial assets amounted to about $340 trillion). Unlike in the U.S., China's traditional banks are a big driver of shadow banking, often as a means to circumvent regulatory controls on lending. They've contributed to the breakneck growth of $4.2 trillion of wealth-management products — opaque investments that have drawn parallels with Western lenders' exposures in the subprime crisis. However, China last year added WMPs to its required health checks for banks and, as part of a broader crackdown on financial risk, announced a sweeping plan to rein in shadow banking. That's already having an impact: WMP growth has slowed and the issuance of another popular investment — trust products that are seen as even riskier — has fallen sharply in 2018. In the U.S., insurance companies have joined hedge funds, private equity shops and tech startups in the ranks of shadow banks by making loans as persistently meager interest rates have cut the returns on traditional investments. Regulators in the U.S., meantime, have stepped up inquiries into Wall Street practices.


The Background

Economist Paul McCulley coined the term “shadow banking” in 2007, but credit has existed outside the banking system for centuries. As banks became the backbone of finance, governments introduced rules to safeguard people's savings and rein in risk-taking by banks. Yet mechanisms to take advantage of being outside that regulation always found a way in. Money-market funds attracted U.S. savers as inflation soared in the 1970s by offering higher interest rates than banks, whose rates were capped. In China, investors turned to wealth-management products for their superior returns — and in the belief they are implicitly guaranteed by banks. Globally, small businesses starved of bank credit and banks dodging curbs on their activities are also part of the picture. Because banks typically have deposit insurance, people don't rush to withdraw funds in times of trouble. Shadow banks, which don't have that safeguard, can see panicked investors flee and trigger a financial meltdown, regulators worry. In the 2008 crisis, the U.S. and European governments didn't only rush to bail out failing banks but had to commit trillions of dollars to prop up the shadow-banking system. The regulated banking sector's ties to shadow banks — such as borrowing from money-market funds or derivative transactions with hedge funds — also pose dangers in times of crisis.

The Argument

Why don’t governments crack down? Regulate all entities that collect deposits and make loans, under whatever guise? There have been some regulation efforts in the U.S. since the crisis, but fierce lobbying by the financial industry has kept most of it at bay. Chinese regulators have targeted peer-to-peer lending following a giant Ponzi scheme, grappled with a $3.8 trillion trust industry and tightened rules on wealth-management products. But for many countries, the shadow-banking sector provides grease to keep economies functioning smoothly. Small businesses get the loans they need; savers get better returns. Reining it in can be the right long-term policy, but can slow growth and raise short-term risks. Government officials know that shadow banking presents a danger — and that they attack it at their peril.

The Reference Shelf

    First published Jan. 8, 2014

    To contact the writer of this QuickTake:
    Jun Luo in Shanghai at jluo6@bloomberg.net

    To contact the editor responsible for this QuickTake:
    Grant Clark at gclark@bloomberg.net

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