Shadow Banking
Regulatory Compliance and Financial Stability

Shadow Banking: Non-bank Credit Intermediation Heightens Risks for the Global Financial System

Author: Sheila Judd, Executive in Residence, Global Risk Institute

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OVERVIEW

Shadow banking generally refers to credit intermediation activities performed outside of the banking system.

On the plus side, shadow banks increase overall credit availability, providing more sources of liquidity, thereby supporting economic growth and diversifying risk across the financial system.

On the negative side, while shadow banks can take on similar risks to banks, they are not subject to the same risk controls required by bank regulators because they do not take in deposits; further, shadow banks do not have the benefit of government backstops that are intended to prevent runs and panics and ensure financial market stability.

As was demonstrated in the 2007-2009 global financial crisis, failures within the shadow banking sector can spread to the broader markets and cause significant disruption. Regulatory reforms have since been implemented to increase the resiliency of the financial system. The Basel Committee on Banking Supervision has introduced numerous new and/or enhanced standards governing banks, and banks are now subject to more stringent capital requirements, as well as new leverage and liquidity tests. Specific to shadow banking, the Financial Stability Board (FSB) has developed a framework to improve monitoring as well as regulatory coverage of the non-bank sector. Further, the riskiest shadow banking activities, including use of opaque off-balance sheet vehicles and reliance on volatile securities as collateral for financing, as well as concentration of counterparty risk for derivatives, have been addressed through specific rules.

However, regulation for shadow banks remains much less robust than it does for banks. In particular, the capital, leverage and liquidity reforms that have been implemented post the financial crisis apply only to banks, allowing shadow banks to take on higher levels of risk. Implementation of a consistent approach to assessing and mitigating shadow banking risks across the globe remains challenging because the activities within the sector are diverse and continue to evolve.

The global shadow banking sector is growing, fuelled by the increased regulation for banks, combined with an increase in the overall demand for credit, as well as appetite for innovative, technology-based products. Investors, both institutional and retail, searching for yield in the low interest rate environment have provided the necessary funding for the sector’s expansion.

A growing and evolving sector, with similar risks but fewer formal risk controls, leads one to question whether the existing governance approach is sufficient. Our view is that more needs to be done to make the global financial system safer and to curtail regulatory arbitrage.

In particular, we recommend that national regulators introduce a minimum liquidity requirement for their systemically important non-bank entities as a starting point to reduce the risk of a shadow banking sector liquidity event creating a crisis for the broader financial markets.

We also recommend:

  • Increasing the disclosure provided to consumers that borrow from non-bank entities. The products they offer can expose already vulnerable borrowers to significant leverage and the downside risks and impacts should be clearly understood; and
  • Improving the disclosure for investors in the growing array of credit-related investment products so that the associated risks to capital, as well as the ability to redeem their investments, are made clear.

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