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.
Regulators are taking note, with China issuing a flurry of directives in 2017 to rein in shadow finance and the U.S. stepping up inquiries into Wall Street practices. Global shadow banking assets continue to rise, though by exactly how much has been harder to gauge as China failed to submit key data in time for an annual report prepared by the Financial Stability Board. Excluding China and Luxembourg (another hub of non-bank lending), the board found shadow banking assets that posed risks to the financial system grew by 3.2 percent to $34.2 trillion in 2015. The board is concerned about excessive borrowing and the potential fallout if businesses were suddenly unable to get loans or renew them. The U.S. had the biggest chunk of the risky assets, followed by the Cayman Islands, Japan and Ireland. 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 low interest rates have cut the returns on traditional investments. In another study, two-thirds of China's shadow-banking network — among the fastest-growing in major economies — amounted to “bank loans in disguise.” Alarm bells have sounded over the country's rapid buildup of $3.8 trillion of wealth-management products — opaque investments that are mostly kept off banks' balance sheets, drawing parallels with Western lenders' exposures in the subprime crisis. China's central bank this year added the off-balance-sheet products to its health checks for lenders.
Economist Paul McCulley coined the term “shadow banking” in 2007, but credit intermediation 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.
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 $2.6 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
- Bloomberg News has a collection of articles on shadow banking.
- QuickTakes on peer-to-peer lending, China's debt bomb and money-market funds, and a Q&A on wealth management products and another on entrusted bonds.
- Financial Stability Board’s Global Shadow Banking Monitoring Report 2015 and the 2016 report.
- A primer on China's shadow banking by the Brookings Institution.
- A Chinese financier defends shadow banking and recounts his experiences in a book. Excerpts are at Bloomberg View.
- Bloomberg Editor-at-Large Sheridan Prasso and China Finance Reporter Jun Luo provided background on shadow banking in China in testimony submitted in March 2013 to the U.S.-China Economic and Security Review Commission of the U.S. Congress.
Sheridan Prasso contributed to the original version of this article.
First published Jan. 8, 2014
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