As summer turned to fall, global regulators focused their attention on shadow banks. Shadow banking, as defined by former Chairman of the Federal Reserve Ben S. Bernanke, "comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions--but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions." Last Wednesday the International Monetary Fund published its latest “Global Financial Stability Report,” which focused on that subject. The report analyzed the growth in shadow banking in recent years in both advanced and emerging market economies and the risks involved. It found that shadow banking appears when strict banking regulations are adopted and grows when real interest rates and yield spreads are low and a large institutional demand for “safe assets” exists. The risks associated with shadow banking come from its reliance on short-term funding. In the United States, shadow banking accounts for at least a third of total systemic risk, similar to that of banks.
In August, the European Central Bank published a paper entitled “Banks, Shadow Banking and Fragility.” The paper studied the relationships between regulated commercial banks and unregulated shadow banks. It found that the relative size of the shadow banking sector determines the stability of the financial system. If the shadow banking sector is small relative to the capacity of secondary markets for shadow banks’ assets, shadow banking is stable. But if the sector grows too large, it becomes fragile and the return to equilibrium is marked by a panic- based run in the shadow banking sector. A second conclusion of the paper was that when the regulated banking system itself operates shadow banks, a large shadow banking system is sustainable. The risk of contagion exists, however, in that scenario.
Also in August the Financial Stability Board issued two regional consultative group reports, one on shadow banking, one focused on the Americas and the other on Asia.
The report on the Americas provides a “map” which analyzes the nature of shadow banking in the region, its connections with the rest of the financial sector, and the risks those connections pose. The report identifies four types of shadow banking entities in the region that may merit further attention because of the potential risk their activities pose to financial stability in specific jurisdictions. These are: (i) open-ended investment funds that hold illiquid assets; (ii) large and highly leveraged broker dealers; (iii) non-bank deposit-taking institutions; and (iv) finance companies.
The report on Asia addresses the profile of non-bank financial intermediaries (“NBFI”) in Asia, how these entities are regulated, how these entities are defined, the distinction between shadow banking and NBFIs in Asia, and the potential risks emanating from NBFIs in Asia.