Shadow Banking

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.

India gave a reminder of how shadow banking blowups can come out of nowhere when one of its biggest providers of infrastructure finance defaulted on debt in August. Infrastructure Leasing & Financial Services Ltd., which funds projects including roads and tunnels, got into trouble as short-term financing costs jumped, raising questions about other Indian shadow banks that rely on such funding. Globally, shadow banking assets have continued to surge, propelled by investors eager for higher returns in a low interest rate world and companies and local governments hungry 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, the most recent year it has assessed. (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.