IBPS PO INTERVIEW -- SHADOW BANKING

Shadow banking refers to all the non-bank financial intermediaries that provide services similar to those of traditional commercial banks. They generally carry out traditional banking functions, but do so outside the traditional system of regulated depository institutions. Shadow banking has grown in importance in the last decade or so and was one of the primary factors in the sub-prime mortgage crisis of 2007-2008 and the global recession that followed it.

The term ‘shadow bank’ was coined by Paul McCulley in 2007, with specific reference to American non-bank financial institutions that used short-term deposits to finance long-term loans. Later, the Financial Stability Board defined shadow banking as the ‘credit intermediation involving entities and activities (fully or partially) outside the regular banking system’. Thus, shadow banking activities include:-

• Credit intermediation – Any kind of lending activity including at least one intermediary between the saver and the borrower
• Liquidity transformation – Usage of short-term debts like deposits or cash-like liabilities to finance long-term investments like loans.
• Maturity transformation – Using short-term liabilities to fund investment in long-term assets

Contents [hide]

•  Prevalence of Shadow Banking
•  Size of Shadow Banks
• Conditions conducive to Shadow Banking
•  Differences between Shadow Banks and Banks
•  Regulation of Shadow Bank Activities
• Challenges faced by regulating agencies in monitoring of shadow banks
•  Dangers of Shadow Banking
• Shadow Banking in the Indian context
•  Challenges posed by shadow banks/NBFCs in the Indian context
• Conclusion

 Prevalence of Shadow Banking

Shadow Banking is found in all economies across the world, be it in developed countries or developing countries, or countries with mature financial markets or those without. Though it is universal, shadow banking takes on different forms in different economies. In advanced economies, shadow banking institutions perform the function of risk transformation through securitization. In less developed economies, where the financial markets are still at a nascent stage, the shadow banking institutions play a supplementary role to traditional banking activities. The only commonality is that in both scenarios, these institutions operate outside the regular banking system, meaning that they function in an environment of lesser transparency and regulation than those institutions performing the same functions in the mainstream banking arena.

 Size of Shadow Banks

According to a report by the Financial Stability Board, USA and the Eurozone alone account for one-third of the global shadow banking assets, which stood at $75 trillion in 2013. This 75 trillion accounts for about 25% of the total financial assets. The three jurisdictions accounting for most of the shadow banking activities are:-

• Eurozone area
• UK
• China

In India, Russia, Argentina, Turkey, Indonesia, and Saudi Arabia the amount of non-bank financial activity remained below 20% of GDP at the end of 2012. However, the sector is growing rapidly.

Conditions conducive to Shadow Banking

According to a report by the Financial Stability Board, the prevalence of the following conditions spur the growth of institutions engaging in shadow banking activities:-

• Strict banking rules combined with low real interest rates and yield rates
• Existence of a large pool of investors searching for higher returns
• Large demand for assets from institutions

 Differences between Shadow Banks and Banks

• Shadow banks cannot create money unlike commercial banks, which by virtue of being depository institutions can do so
• Banks are comprehensively and tightly regulated, whereas shadow banks lacks regulatory oversight and transparency with respect to its business operations
• Commercial banks raise funds through mobilization of public deposits to a large extent. Shadow banks, on the other hand, raise funds mostly through market-based instruments such as commercial paper, debentures, or other such structured credit instruments
• While the liabilities of the shadow banks are uninsured, commercial banks’ deposits enjoy Government guarantee to a limited extent generally
• During times of distress, banks have access to multiple recourses set up by the body responsible for regulatory oversight such as direct access to central bank liquidity etc. However, shadow banks have no such options, and will have to fend for themselves

There is a stark differences in the way the shadow banks operate as compared to other traditional banks. However, in certain instances there is only a thin line separating the two.

 Regulation of Shadow Bank Activities

Shadow Banking institutions exploit the prevalent economic system’s inefficiencies through financial innovations. However, the sub-prime crisis exposed the extent of damage that can be caused by unregulated banking activities. The crisis and the recession that followed it provoked a call for increased regulation of the markets globally.

USA passed the Dodd-Frank Act in 2010 to strengthen the arms of the Federal Reserve to regulate all institutions of systemic importance. The EU (European Union) has also put in place some measures regulating securitization and credit rating agencies. Also, the Financial Security Board, at the specific request of G-20 countries, has been working towards ‘strengthening the oversight and regulation of the shadow banking system so that the risks emanating from them may be mitigated.’ India is also working towards improving the regulatory framework so as to curb the shadow banking activities that risk financial stability.

Challenges faced by regulating agencies in monitoring of shadow banks

Below are some of the challenges posed to regulatory agencies by shadow banks:-

• Though its dangers have been emphasized upon as of late, shadow banks were in existence even in the late 1950s. Its influence and rate of prevalence grew and fell as the role of the banking system in a country fell and grew. As one rose, the other fell and vice versa. Hence, it is a challenge in itself to regulate a phenomenon that has been in existence for decades and weathered many a storm.
• It is difficult for regulating agencies to exactly determine the magnitude of shadow banking as they are continually evolving to find loopholes in the regulatory framework. There are hardly any reliable statistics available at the domestic level concerning the nature of shadow banking entities, their instruments and their activities.

 Dangers of Shadow Banking

• Financial Stability and Systemic Risk Concerns – Shadow Banking acts as a means to escape regulatory oversight. In many instances, banks themselves composed part of the shadow banking chain by floating a specialized subsidiary to carry out shadow banking activities. Also, banks may invest in financial products issued by other shadow banking entities. And since shadow bank entities have no access to recourse to central bank funding or any other safety nets, they remain vulnerable to shocks. Such inter-linkages and the huge size of shadow bank activities give rise to systemic risk concern, as a seemingly minor issue affecting one entity may amplify and send shocks through the system. And the capacity of shadow banks to precipitate systemic crisis as manifested in the recent global financial crisis is still fresh in the minds of the people.
• Regulatory arbitrage spread across geographical jurisdictions – Shadow banking activities are spread across border and different legal and regulatory frameworks across geographical jurisdictions pose a handicap in curbing them. For instance, high taxation in some countries may lead to adoption of tax avoidance strategies by financial firms. Tax haven countries keep taxes low to attract foreign capital and create jobs. So, companies in high taxation countries restructure their financial activity by shifting some high tax activities to low tax countries. This, at times, has an adverse effect on financial stability, especially when the whole global economy is highly integrated and interconnected.
• Challenges in the conduct of Monetary Policy – ‘Opaqueness of structure, size, operations and inter-linkages of shadow banks with commercial banks and other arms of the financial sector distorts the information content of monetary policy indicators and undermines the conduct of monetary policy.’ Central Banks and other regulatory agencies depend on domestic indicators while determining monetary policy, which is modified at regular intervals. Lack of clarity as to the activities conducted in the financial system prohibits it from formulating a coherent policy that tackles all the urgent issues. Since these entities broadly remain outside the regulatory purview, a clear picture of the extent of their activities and involvement in the financial system is lacking. Therefore, these non-bank financial intermediaries act as an impediment to the successful implementation of monetary policy as they remain immune to direct central bank control. A Study has found that ‘growing level of intermediation activities of the non-bank financial intermediaries causes a shift in deposits from banks to non-banks in South-East Asian Countries.
• Procyclicity and amplification of business cycles – Shadow banking activities have a tendency to act pro-cyclically. Pro-cyclicity means that that there is a positive correlation between the activity in question and the overall condition of the economy. This means that when there is an economic boom, the activities of shadow banks are on the rise and when there is a downturn, they shrink their activities. This amplifies financial and economic cycles. ‘Their leverage would rise during booms as they face little problem in arranging funds as assets price rise and margins on secured lending remain low. On the contrary, during the downturn phase as the funding becomes difficult and asset prices fall, the margins on secured loan become tighter, shadow banks get compelled to undertake deleveraging.’ Also, pro-cyclicality of shadow banks worsen due to their inter-connectedness with banks. According to the Financial Stability Board, inter-connectedness of the shadow banks with the banks heighten the risks of asset price bubbles like the one that occurred before 2008.

Shadow Banking in the Indian context

In the Indian financial arena, shadow banks are known as Non-Banking Finance Companies (NBFCs). However, NBFCs in India have been regulated by the RBI (Reserve Bank of India) since 1963.

• Regulation of NBFCs in India began in the wake of failure of several banks in the late 1950s and early 1960s where a large number of ordinary depositors lost money. The Deposit Insurance Corporation was formed by RBI to provide the necessary safety net for the bank depositors.
• Later in 1996, the regulatory structure over the NBFCs was further tightened with rigorous registration requirements, enhanced reporting and supervision.
• RBI also prohibited NBFCs from raising deposits from the public. However, this led the NBFCs to source their funding from the banking system, thereby raising systemic risk issues. So, the RBI brought asset side prudential regulations onto the NBFCs.

 Challenges posed by shadow banks/NBFCs in the Indian context

• RBI has multiple responsibilities such as to address the risks posed by shadow banks to financial stability, address depositors’ and customers’ interests, address regulatory arbitrage and also help the financial sector grow in a healthy and efficient manner.
• RBI faces various law related challenges such as dealing with differing entities that are:-
• registered as finance companies, but do not come under the regulatory supervision of the RBI
• unincorporated bodies who undertake financial activities and remain unregulated
• incorporated companies and unincorporated entities illegally accepting deposits
• entities camouflaging deposits in some other names and thus illegally accepting deposits

The fact is that the law is ill-equipped to deal with such innovative measures that exploit the legal mechanism which is currently in place. There is a need to bring in suitable amendments to the statutory provisions.

• Shadow banking entities, especially those that are unincorporated can spring up anywhere and operate with impunity. Therefore, there is a need to put in place a structure for effective market intelligence gathering to that action may be taken as soon as possible against such entities to secure interests of consumers.
• There is a multiplicity of agencies involved in regulating the non-banking financial activities of entities leading to major overlap. The central government ministries like Finance and Corporate Affairs, agencies like CBI and FIU-IND (Financial Intelligence Unit – India), regulatory agencies like the Reserve Bank, SEBI, the Registrar of Companies, state government agencies like the police and others are all entitled to work on different aspects involving NBFCs and other shadow banks. These agencies have to share information and coordinate and cooperate to bring in an effective, timely and unified enforcement of the law. To overcome this hurdle, RBI is strengthening its State Level Coordination Committees (SLCC) and is considering setting up of National level Coordination Committee is also being considered.
• The RBI has been tightening regulations governing the 12,000 NBFCs that are registered with it, during the past year. However, it is yet to address the issues of unregulated chit funds or small investment funds that proliferate at the regional level. It is believed that India there are roughly 18,000 collective investment funds raising money from small investors, often by promising exaggerated returns. There are no composite statistics on the quantum of money raises by such funds, but the recent scam run by the Saradha Group in West Bengal has wiped out as much as $3.7 billion in deposits.

Conclusion

Though the disadvantages and risks of shadow banks have been highlighted here, it is undeniable that shadow banks, including NBFCs and other service a need of the population that is left unaddressed by the mainstream banks. Shadow banks subserve the economy by playing a complimentary and supplementary role to mainstream banks and also aid in furthering financial inclusion, which is an important issue for India. Large banks due to their reluctance to enter into less profitable areas, have left 41% of Indian households without bank accounts, thus making them an easy target for chit funds. Hence, instead of aiming to completely abolish shadow banking, the Government must increase regulatory oversight and keep the law/rules updated to dealing with the changing economic environment. While enabling prudential growth of the sector, financial stability must be maintained and consumers’ and depositors’ interests must be protected.

https://www.gktoday.in/gk/shadow-banking/