A Closer Look at Shadow Banking

• The term “Shadow Bank” was first introduced by economist Paul McCulley in 2007 during the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming.
• The global financial crisis highlighted the failures of the financial system, and shadow banking was a significant part of this.
• Shadow banks borrow short-term funds from the money markets and use these funds to purchase longer-term assets.
• Important components of the shadow banking system include mortgage companies, investment banks, repurchase agreement markets, money market funds, asset-backed commercial paper [ABCP] conduits, and securitization vehicles.
• The definition and scope of shadow banking are a subject of debate in academic literature.
• Entities that fall under shadow banking include credit insurance providers, securities broker-dealers, private equity funds, credit hedge funds, exchange-traded funds, credit investment funds, structured investment vehicles (SIV), and hedge funds.
• Shadow banks came into the limelight due to their increasing involvement in transforming home mortgages into securities.
• The Financial Stability Board (FSB), an organization of supervisory and financial authorities from international financial institutions and major economies, developed a broader definition of shadow banks. This included all entities that performed core banking functions and were outside the regulated banking system.

Shadow Banking in the Indian Context

• The shadow banking sector in India is relatively smaller compared to its counterparts in developed economies.
• According to 2011 data provided by the Reserve Bank of India (RBI), the assets of the bank were 86 per cent of GDP, while the assets of the shadow banking system accounted for 21 per cent of GDP.
• The activities of these entities are limited, and many of the activities that contributed to the global crisis are either regulated or not allowed in India.
• Complex and synthetic derivative products, which were at the core of the global crisis, are not currently permitted in India.
• Banks in India do not use the model of transferring risk off-balance sheet using SIVs/ conduits.
• Hedge Funds do not play a significant role in India.

The Advantages of Shadow Banking

• The primary benefits of shadow banks include prompt service provision, customer orientation, quick decision-making ability, and lower operation transaction costs.
• Shadow banking activities form an integral part of the financial system.
• The term 'shadow banking' does not imply anything negative or sinister.
• For instance, Non-Banking Finance Companies (NBFCs), which are part of shadow banking, play a vital role in diversifying the financial sector, enhancing competition, and broadening access to financial services.

The Risks Associated with Shadow Banking

• Shadow banks can pose risks due to their interconnectedness with the banking system, their cross-jurisdictional nature, and their complexity. These risks can potentially assume a systemic dimension.
• The four types of risks that emanate from shadow banking are contagion risks, regulatory arbitrage, leverage risk, and liquidity risk.

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