Flying blind: how shadow banks in emerging markets have become the global economy's greatest threat.

• Author: Borst, Nicholas

In the wake of the global financial crisis, financial regulators worldwide have struggled to adequately address the risks inherent in shadow banking. In the advanced economies, post-crisis regulatory efforts have tamed some of the previous excesses and slowed the growth of shadow banking. Despite these efforts, the shadow banking systems in Europe and the United States remain large and under-regulated. In emerging markets, shadow banking systems have continued to grow rapidly and risks are accumulating. Perhaps this is why Financial Stability Board Chairman (and Bank of England Governor) Mark Carney recently described shadow banking excesses in emerging markets as posing the biggest threat to the global economy. The threat centers around China, which is now the world's second-largest economy and has the largest shadow banking system among the emerging market countries.

For all its expressed concern about the dangers of shadow banking in emerging markets, the Financial Stability Board s approach to addressing the problem is surprisingly ineffective. Its effort to monitor shadow banking in the world's largest emerging market is marred by a lack of transparency and a methodology designed for Anglo-American financial systems rather than those in emerging markets. These deficiencies result in a significant underestimate of the size of the shadow banking system in China and give cover to those who wish to prevent regulatory action.

The international focus on shadow banking is recent. This is understandable given that the concept of shadow banking itself is relatively new. The first usage of the term is ascribed to former PIMCO economist Paul McCulley in 2007. Awareness of shadow banking grew during the global financial crisis, when many bank-linked special purpose vehicles went bad and brought down the banks with them. In subsequent years, the label of shadow banking has been applied to a variety of financial structures, ranging from relatively common financial products such as money market mutual funds and real estate investment trusts to the more exotic, such as hedge funds and structured finance vehicles.

In the wake of the crisis, there was a general consensus that there needed to be a comprehensive and internationally coordinated response to shadow banking. The Group of 20, an international grouping of the twenty largest economies, decided during the November 2010 Seoul summit to strengthen the regulation and supervision of shadow banking...