Shadow Banking
Shadow banking refers to credit intermediation that takes place outside the traditional banking system, through entities and activities that perform bank-like functions but are not subject to the same regulation. The term encompasses money market funds, hedge funds, structured investment vehicles, and other institutions and activities involved in the creation and intermediation of credit.
Scope and Activities
Shadow banking includes a wide range of entities and activities. Money market funds collect short-term funds and invest them in short-term securities, performing a function similar to bank deposits. Securitisation transforms loans into tradable securities, moving assets off the balance sheets of banks. Repurchase agreements provide short-term secured funding, and other instruments provide credit and liquidity.
These activities perform the functions of banking, including maturity transformation and credit creation, but outside the regulated banking sector. They can enhance the efficiency of credit intermediation, providing alternative sources of funding and of investment. They can also create risks, including leverage, maturity mismatch, and interconnectedness.
Risks and Vulnerabilities
Shadow banking can be subject to runs, since many of its liabilities are short-term and are perceived as safe, while its assets are longer-term and less liquid. A run can occur when investors lose confidence and withdraw their funds, forcing asset sales and transmitting stress to other institutions and markets.
The interconnections between shadow banking and the regulated banking system are a particular concern. Banks may sponsor or fund shadow banking entities, or rely on them for funding, so that stress in one part of the system can spread to others. The opacity of some shadow banking activities complicates the assessment of these linkages.
Regulation
Regulation of shadow banking seeks to address the risks while preserving the benefits of alternative credit intermediation. Measures include the regulation of money market funds, the oversight of securitisation, and the application of prudential requirements to non-bank financial institutions.
International bodies have developed frameworks for monitoring and regulating shadow banking, recognising the cross-border nature of the activities. The challenge is to design regulation that addresses the risks without driving activity into less regulated areas or impairing the supply of credit.
Significance
Shadow banking has grown substantially in many economies, becoming an important source of credit and a potential source of systemic risk. Its growth reflects regulatory arbitrage, the search for yield, and the demand for alternative funding and investment.
The analysis of shadow banking informs the assessment of financial stability and the design of regulation. It also highlights the importance of monitoring developments in the financial system and of coordinating regulation across sectors and jurisdictions, since the risks can migrate to areas outside the scope of traditional oversight.
Money Market Funds
Money market funds are a prominent component of shadow banking. They collect short-term funds from investors and invest in short-term securities, offering shareholders a stable value and ready redemption. They perform a function similar to bank deposits but without deposit insurance or access to central bank liquidity facilities.
The stable value of money market fund shares can be threatened if the fund's assets decline in value, creating the possibility of a run. The experience of the global financial crisis, when a prominent fund broke the buck and triggered widespread withdrawals, illustrates the vulnerability of these institutions and has motivated regulatory reform.
Securitisation
Securitisation transforms loans into tradable securities, allowing banks to move assets off their balance sheets and to fund lending through capital markets. The process can improve the efficiency of credit intermediation, diversifying risk and reducing the cost of funding.
Securitisation can also create risks. Origination and funding are separated, reducing the incentive of originators to monitor borrowers. The complexity of some securities makes it difficult for investors to assess their value, and the reliance on ratings can create problems when the ratings prove inaccurate. These features contributed to the global financial crisis, and they have motivated reforms to the securitisation process.
Repurchase Agreements
Repurchase agreements, or repos, are short-term secured borrowings in which one party sells a security and agrees to repurchase it at a higher price. Repos are a key source of short-term funding for financial institutions and a key instrument of central bank operations.
The repo market is central to the functioning of the financial system, and its disruption can transmit stress widely. The experience of crises, when repo funding contracted sharply, illustrates the importance of this market and has motivated measures to enhance its resilience.
Monitoring and Regulation
Monitoring shadow banking requires data on the activities and interconnections of non-bank financial institutions. International bodies have developed frameworks for monitoring, and national authorities have strengthened oversight of specific institutions and activities.
The challenge is to regulate shadow banking without driving activity into less regulated areas and without impairing the supply of credit. The design of regulation must address the risks while preserving the benefits of alternative credit intermediation, and it must be coordinated across jurisdictions, since the activities are often cross-border.