Financial institutions that operate outside the traditional banking system but perform similar functions, such as lending money or facilitating investments, are rather ominously known as shadow banks.
Politicians and economists have warned that shadow banking, when left to its own devices, has the potential to trigger a financial collapse. Last year, the Bank of England’s governor, Andrew Bailey, sounded the alarm on the risky nature of shadow banking. “The non-bank sector is very large and growing,” he said. “It is disparate in nature, opaque in important places and the interlinkages are, unsurprisingly, therefore complex and hard to observe.”
So what are these non-banking entities – and why do they inspire such fear?
How does shadow banking work?
The term ‘shadow bank’ was coined in 2007 by economist Paul McCulley to describe institutions that look like banks and do what banks do – but aren’t really banks. They do not take deposits but they often borrow and lend large amounts of money.
Examples of shadow banks include hedge funds, private equity firms, mobile payment systems and bond-trading platforms.
Despite what the name suggests, shadow banks need not always be a bad thing. They offer an additional source of credit to businesses and individuals in countries where traditional banking is absent. They also take some of the burden off regular banks, creating a healthier, more diversified financial system.
On the other hand, they are not subject to the same regulation and oversight as traditional banks, which means they can take on higher risks. They can, for example, lend to borrowers who might not qualify for regular bank loans.
Shadow banks tend to borrow money for a short period to fund long-term investments, like real-estate loans or mortgages. This style of lending can pose a significant threat. If investors panic and pull their money out quickly due to market volatility, or a large number of borrowers suddenly default, shadow banks can struggle to sell their long-term assets fast enough to repay, which can lead to their collapse.
Twenty years ago, the collapse of shadow banking played a major role in the 2008 financial crash. The rapid credit freeze turned a financial shock into a full-blown crisis.
What threat do shadow banks pose today?
These under-regulated bogeymen of the financial system are growing in number. Shadow banking now accounts for almost half (49%) of the world’s financial assets – around $250tn (£186tn) – according to the Financial Stability Board, an international watchdog.
The current carnage in global stock and bond markets wrought by President Donald Trump’s trade war has raised concerns about another potential liquidity crunch. There is a risk that all these companies relying on shadow banks for funding could start to default if tariffs squeeze their profits, triggering a 2008-style crash.
As financial markets continue to evolve, it remains a challenge for regulators to strike the right balance between promoting innovation and safeguarding financial stability in the shadow banking sector. Addressing these challenges effectively is essential for reducing the potential threats that shadow banking can pose to the broader financial system.
Financial institutions that operate outside the traditional banking system but perform similar functions, such as lending money or facilitating investments, are rather ominously known as shadow banks.
Politicians and economists have warned that shadow banking, when left to its own devices, has the potential to trigger a financial collapse. Last year, the Bank of England’s governor, Andrew Bailey, sounded the alarm on the risky nature of shadow banking. “The non-bank sector is very large and growing,” he said. “It is disparate in nature, opaque in important places and the interlinkages are, unsurprisingly, therefore complex and hard to observe.”
So what are these non-banking entities – and why do they inspire such fear?
