Shadow Banking: The Rise, Fall and Future

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Shadow banking is a system of financial institutions who conduct business outside the regulatory framework. In other words, it involves those activities that cannot be monitored by regulatory authorities, and are untraceable in the books of accounts of the participating institutions. The most common form of legal entities that fall under shadow banking are: hedge funds, structured investment vehicles (SIVs), special purpose entity conduits (SPE), money market funds, repurchase order agreement (repo) markets and other non-bank financial institutions.

Shadow banking has been around for a while;  but only recently has been in the headlines. News coverage has increased as shadow banking began to receive criticism over its impact in financial institutions. Rapid growth in the volume of assets under the shadow banking system (SBS) stated in, 2000, and in 2004, the Deloitte Shadow Banking Index was born. With an estimated size of between $10-60 trillion, the shadow banking system, at the high end of the range, is almost equal to world GDP. There have been several rules drafted or enacted to curb the size of this sector.

Shadow Banking: The Rise, Fall and Future

Adam Schneider, , Executive Director at the Deloitte Center for Financial Services, claims that the Deloitte Shadow banking index was started to define and quantify the sector (shadow banking) over time including components. He states, “This ongoing effort is designed to more closely measure size, importance, effect of the market, and impact of regulatory actions, as well as a way to assess the potential impact of shadow banking on regulated markets.” He likens shadow banking to conventional banking as they both carry the attributes of depositing funds, but contrasts the two in the sense that shadow banking cannot seek liquidity support from the central bank and does not have the “bank-like insurance”, as compared to conventional banking.

The Deloitte shadow banking index has experienced a decline. The index base of 100 in 2004, rallied to a high of 162.5, with assets valued at over $20 trillion in the first quarter of 2008. However, the global financial crises of 2008/2009, caused the sector to shrink. The crisis which was to some extent orchestrated by shadow banking activities, where investment banks financed mortgages through off-balance sheet securitizations and hedged risk through off-balance sheet credit default swaps, held down the rapid growth as scrutiny over the  sector increased.  The asset value fell by more than 50%, to a low of $9.5 trillion, and the  index was at 75 basis points in Q4 2011.

Schneider believes that shadow banking is an integral part of the financial system, as it rivals the regular banking. I agree that it makes the banking environment more competitive.. However, as we continue to wait to see what the future has for this sector, there are challenges on the horizon.

Schneider mentions that the Financial Stability Board (FSB) will be receiving recommendations from the G20 on regulations over the SBS.

On April 10th, 2012, Federal Reserve Chairman, Ben S. Bernanke, recommended a closer look into SBS, to avoid future crises. The following day, April 11, a28 year old Wu Ying ‘Rich Sister’ was sentenced to death in China for taking $55.7 million from investors without paying them back. The $55.7 million  was related to the SBS. These are just a few of the predicaments shadow banking faces.

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