The shadow banking system, also referred to as the shadow financial system, has been informally described as the unregulated financial activities conducted by regulated institutions. They refer to the financial intermediaries, which are involved in the facilitation of the creation of credit across the global financial system. The members of the shadow banking systems are not subject to regulatory oversight. It also refers to the network of financial institutions, which are comprised of non-depository banks, for example structured investment vehicle, investment banks, hedge funds, conduits, money market funds, and non-bank financial institutions (Batchvarov, 2013, p. 348). Shadow banking institutions usually serve as the intermediaries between the borrowers and the investors by providing capital and credit for the investors, corporations, and institutional investors. These institutions get their profits from fees and the arbitrage in the interest rates charged on the borrowings.
The shadow banking system is asserted to have been built alongside the traditional banking system using some of the modern finance tools such as credit default swaps and interest rate swaps. The major idea behind the formation of these financial institutions was to ensure that credit was more available and cheaper for the ultimate borrower. The founders also intended to separate the payment system from the credit system. It is assumed that most of the regulations put on the banking systems are aimed at protecting the payment system and less of the credit system. The traditional banking systems were the founders of the loans system. They packaged, securitized, and sold the loans to the shadow banking system, which was further charged with the responsibility of raising the funds from asset-backed commercial papers and mutual funds in the money market. However, despite getting rid of the credit risks and interest risks from the balance sheets of the traditional banks, the shadow banking systems could not get rid of the solvency or liquidity risks, which has been one of the major arguments of the proponents of imposing stringent regulations on the shadow banking system.
The traditional commercial banking system invests in long term loans and finances these loans through the issuance of short term deposits. Similarly, the shadow banking system invests in securities based on akin sorts of long-term loans such as auto loans or mortgages, and finances these investments through the issuance of short term claims such as repo or commercial paper. However, as opposed to the traditional commercial banking system, the shadow banking system uses short term financing, which is not insured by the Federal Reserve. They do not also borrow from the Federal Reserve’s discount window, which is accessible by the traditional commercial banking system. The shadow banking system has escaped government regulations basically because they do not accept bank deposits from savers. Consequently, many of the instruments and institutions were able to employ credit and liquidity risks, higher market, and lacked the capital requirements corresponding to these risks.
Following the 2008 financial crisis, there have been persistent concerns from academics, regulators, and other new regulations on the shadow banking system. Despite the lack of rigorous definition of the contours of this system, it includes several firms with active participation in the securities markets. In the past three decades, the securities markets have displaced commercial banks as the principle source of finances for real economy, majorly because securities intermediation is more efficient than the deposit banking (Maggs, 2009, p. 7). There have been conflicting debates on whether the government should impose additional regulations on these shadow bank systems. One of the layman arguments is the famous quote that, if it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck (Rehm, 2011, p. 2). However, these shadow banks operate like banks, but are not banks in themselves.
The calls to impose additional regulations on the shadow banking system are exceedingly hurried. These are rushed decisions because of the fact that both the unregulated and regulated banking systems and the lightly regulated securities markets were engulfed by the financial crisis. The financial crisis was a unique event, which did not have much to do with the inherent stability of the shadow banking system. Therefore, the imposition of the additional regulations on the shadow banking system or the securities market would imply the addition of costs, which will consequently lead to the impairment of the economic growth. Imposing such regulations would only be relevant if the government assessed that the shadow banking system is intrinsically unstable.
The international financial regulations and the United States, alongside several other governments have been calling for the imposition of regulations on the shadow banking system following the advent of the financial crisis. The proponents of these regulations assert that the bankruptcy of the Lehman Brothers as well as the rescue of many other non-bank firms indicated that, these shadow banking institutions pose a potential risk to the stability of global and United States financial system. These proponents also argue that, according to the definitions of the shadow banking system, it implies that the entire securities market should be part of the securities market, which makes the system subject to the regulations imposed on other banking institutions in order to ensure their stability. For instance, in the 2009 G20 leaders’ summit, the Financial Stability Board defined the shadow banking system as “credit intermediation involving entities and activities outside the regular banking system” (Peter, 2012). They also noted that, the concept is interchangeable with entities engaged in “market-based credit intermediation” or “market-based financing” (Peter, 2012).
The propositions for new and more stringent regulations on the shadow banking system seems to be more hurried than its actual importance to the securities markets. Most of the financial observers rely on the single event of the 2008 financial crisis, which hit the United States and the whole globe. However, prior to this event, there has never been even a single instance, where the shadow banking system has been found responsible or posing danger to the United States financial system. Additionally, there has never been in the history of the United States, apart from the popular event of the 2008 crisis, when the failure of firms in the United States was associated to shadow banking. Using this single event to claim that large portions of the securities market should be subjected to more stringent regulations in the United States and across the borders similar to those that the commercial banks are subjected to them seems to be a rushed decision. According to a statement of Federal Reserve Chairman, Ben Bernanke, in his speech in 2012 at the Atlanta Federal Reserve Bank, he indicated that, despite the fact that the shadow banking system performs the functions of the traditional banks such as credit maturity transformations and intermediation, as opposed to the traditional commercial banks, the shadow banking system cannot rely on the protections afforded by deposit insurance and access the discount window of the Federal Reserve to ensure their stability in the financial system (Harvard Law Review, 127, 2, pp. 729-750). He also indicated that the shadow banking system depends on alternative sets of regulatory and contractual protections. For instance, during the financial crisis, posting in short term borrowing transactions failed to stave off a classic fear, which spread across the financial system after taking hold of the shadow banking system. During the financial crisis, determining which system was stable between the traditional banking system and the shadow banking system was impossible.
Imposing more stringent regulations on the shadow banking system would be an inappropriate argument, especially in financing and achieving greater economic growth. The access to the Federal Reserve’s deposit insurance and discount window, combined with the regulations, failed to prevent the adverse consequences of the financial crisis throughout the regulated traditional banking system. This, therefore, implies that despite the presence of the regulations on the traditional banking system, which failed to prevent the crisis or the spread of its consequences, imposing similar regulations on the shadow banking system would be a selfish effort of the traditional banks to curb the former. Secondly, imposing such regulations on the shadow banking systems would imply buying stability of the financial system at the expense of a diverse and innovative system of financing through the securities market. This securities market has been researched and proven to more stable and efficient than the deposit banking system for the past thirty years. While the government might be seeking to ensure that there is financial stability through imposing stringent and new regulations on the shadow banking system, this might lead to collapse of the sector, which provides more services with stability than the deposit banking system, which majorly depends on the credit worth of the savers.
The examples such as the rescue of AIG and Bear Stearns and the collapse of the Lehman Brothers have been used to prove the systemic and instability risk intrinsic in the unregulated securities market activities. However, opponents of the regulations assert that this argument lacks historical proof of these claims. The shadow banking system, which has been described to include nearly all of the security markets and money market funds (MMFs), has been comparably stable than the regulated banking system. In contrast to the aforementioned examples of the shadow banking system collapse and rescue, the entire savings and loans system collapsed in the late 1980, and the early ‘90s. This collapse led to about $150 billion cost to the taxpayers. Due to fear of a systemic collapse, the Federal Reserve rescued Continental Illinois in 1984 from failure.
In the 2008 financial Crisis, all the resources of the regulated traditional banking system including the discount window, the prudential regulations, and the deposit insurance, failed to prevent the need to rescue the four major banks such as IdyMac, Citi, Wachovia, and Washington Banks from failure (Daniel, Biddle & Merritt, 2012). These resources also failed to prevent the need to cope up with the Troubled Asset Relief Program funds in about 300 hundred banks, and the failure of four hundred other smaller banks. This is enough proof that the shadow banking system is more stable than the traditional regulated banking system, and that the examples of the shadow banking system given in the assertions are less proof that cannot be used to provide a ground for the imposition of the stringent regulations. This further indicates that there are no regulations or systems that have been put in place to handle the financial crisis. Even providing enough proof that the unregulated shadow bank system poses a threat to the financial stability in the United States and across its borders is an unfounded assertion.
The Chinese Regulations on Shadow Banking
China is one of the latest countries to impose regulations on the shadow banking system according to a report by the Financial Times. It is also reported that China is officially legitimizing this alternative funding source. In a document called for increasing regulation issued by the Chinese State Council, the government recognizes the roles that the shadow banking system plays in the economy in terms of financial development and innovation. According to the Chinese definition of the shadow banking system, they considers this sector as unofficial, illegal, and standardized practices that issue corporate bonds, off-the-books lending, and trust financing.
In these new regulations, the Chinese government asserts that it is aimed at containing the risks associated with the flourishing shadow banking system while also formalizing the role of non bank lenders in the Chinese economy. The Chinese financial system has been dominated by banks that traditionally comprised about 90 percent of all funding in the economy (Tiezzi, 2014). However, the rise of the shadow banking system over the past five years has reduced the command of the traditional banking systems, with most new borrowers resorting to the latter such as trust companies. However, critics argue that the surge in Chinese debt levels as well as reduction in credit flow transparency has been as a result of the boom in the shadow banking system. Nevertheless, according to the proponents, the shadow banking system represent a shift to a more diversified, market led financial system. Even though the Chinese government intends to curb the sector through the new impositions, it is equally argued that the consequences of such regulations might lead to negative effects on the financial system.
Conclusion
The shadow banking system is similar to the traditional banking system in several ways of their operations, but only the fact that they do not accepts deposits from the savers. There has been a growing concern in the United States and across the borders to impose new and stringent regulations on the shadow banking system. For instance, The Financial Times reported in January this year that, the Chinese government is moving toward regulating and legitimizing the shadow banking sector (Tiezzi, 2014). It is evident that following the financial crisis of 2008, different approaches toward ensuring the stability of the financial system in the United States has brought about the propositions such as imposition of the regulations on the shadow banking system.
However, research indicates that, finding a balance on the sector, which caused the financial crisis between the traditional commercial banking system and the shadow banking as unrealistic. Even further, all the resources of the regulated traditional banking system including the discount window, the prudential regulations, and the deposit insurance, failed to prevent the need to rescue the four major banks during the crisis as well as four hundred other smaller banks. Therefore, it would be hurried harsh decision to impose regulations on the shadow banking system without empirical evidence. A better solution should be sought, which seeks to stabilize the financial system, and limit the attention towards one sector and ignoring other options such as redefining the operations traditional of the traditional commercial banks. As a matter of fact, the securities market has proven it stability over the commercial banks for more than three decades, even without these supposed restrictions.
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