The moonshine of our times: the global rise of shadow banking.

Author:Davies, Roger

The infamous American gangster Al Capone once said that "prohibition has made nothing but trouble." Similarly, it is the expansion of banking regulation with a knock-on restriction on lending that has proved the catalyst for the growth of a shadow banking sector now a victim of its own success. The term was coined as much of what goes on lies in the shadows. Banking reform has long been focused on restraining the activities of retail and investment banks, but until an alarm was recently raised about systemic risk, it appears shadow banking has not been on supervisors' main agendas. Most economists, with the benefit of hindsight, are concluding that the risk built up in the shadow banking system played a key part by contagion in the collapse of credit in the 2008 global financial crisis.

The Financial Stability Board defines shadow banking as "credit intermediation involving entities and activities (fully or partly) outside the regular banking system"--essentially, credit obtained outside the banking system. It covers derivatives, money-market funds, securities lending, and repurchase agreements as well as the riskier investment products and loan-shark activities. In November 2014, the FSB published "Transforming Shadow Banking into Resilient Market-based Financing." The FSB was concerned that a largely unregulated sector had grown globally to $75 trillion in 2013, an increase of $5 trillion from the preceding year. The paper also included an updated "roadmap" from the G-20 for the "Strengthened Oversight and Regulation of Shadow Banking in 2015." While the "too big to fail" issue dominates bank supervision, many recognize that the core problem with shadow banking is that it is too diverse to regulate effectively and indeed much activity is hidden from official scrutiny. The FSB is now proposing to combine bank- and market-based finance, its new name for shadow banking, into a more diverse financial system, hoping it will prove more resilient and, through greater competition, more effective.

We should be mindful that net credit growth since the economic crisis has fundamentally been in bond rather than bank finance and the importance of shadow banking to the economic success of China and India cannot be overemphasized. In practice, many shadow banking operations rely on short-term funding, often channelling funds through various unregulated institutions in a chain of transactions with risk building up at each stage. Since the operations are...

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