Everybody has a shadow. Shadows are created when a body gets in the way of light reaching a particular space. This is where the darkness comes from and what the name stands for. However, with the darkness, an unfortunate presence can also be created. Something that would not survive in the light, a creature that can silently endanger anything around it.

In the same way that a shadow can silently endanger you, so can the shadow banking system endanger the financial industry and the economy. That is why we have decided to provide more insight on the topic of shadow banking, what it is and how it can affect your business and even the economy.

• What is Shadow Banking?
• How do Shadow Banks Work?
• Why do we Need Shadow Banking?
• What are the Risks With Shadow Banking?
• Can Shadow Banks Create Money?
• Which Bank is a Shadow Bank?
• Why is Shadow Banking Growing?
• How Big is the Shadow Banking System?
• Where do Shadow Banks Get Their Money?
• Are Insurance Companies Part of Shadow Banking?
• Examples of Shadow Banking
• What is Shadow Debt?

What is Shadow Banking?

The shadow banking system is a group of financial intermediaries which facilitate the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. These companies are often known as nonbank financial companies (NBFCs). The shadow banking system also refers to unregulated activities by regulated institutions.

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Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives, and other unlisted instruments, while examples of unregulated activities by regulated institutions include credit default swaps.

Most of the shadow banking sector is made up of NBFCs, which fall under the oversight of the Dodd-Frank Wall Street Reform and Consumer Protection Act. NBFCs existed long before the Dodd-Frank Act.

In 2007, they were given the moniker “shadow banks” by economist Paul McCulley, at the time the managing director of Pacific Investment Management Company LLC (PIMCO), to describe the expanding matrix of institutions contributing to the then-current easy-money lending environment—which in turn led to the subprime mortgage meltdown and the subsequent 2008 financial crisis.

Although the term “shadow banking” sounds somewhat sinister, many well-known brokerages and investment firms engage in shadow banking activity. Investment bankers Lehman Brothers and Bear Stearns were two of the more famed NBFCs at the center of the 2008 financial crisis.

As a result of that crisis, traditional banks found themselves under closer regulatory scrutiny, which led to a prolonged contraction in their lending activities. As the authorities tightened up on the banks, the banks, in turn, tightened up on loan or credit applicants. The more stringent requirements gave rise to more people needing other funding sources—and hence, the growth of nonbank, “shadow” institutions that were able to operate outside the constraints of banking regulations.

How do Shadow Banks Work?

Like many complex parts of our economy, shadow banking is often misunderstood. However, it is important to know what shadow banking really is, how it supports the economy and the risks it poses. According to the latest Financial Stability Board report, non-bank financing provides an alternative to traditional bank loans and is a major contributor to overall economic activity and growth. However, the benefit of that growth also comes with major risks to the economy.

When most people think of banks, they think of traditional commercial banks like Wells Fargo, Bank of America, Citibank and others. What makes these institutions true banks is the fact that they take deposits from savers and lend them out to borrowers in the form of mortgages, car loans and other debt. These traditional commercial banks are heavily regulated by federal and state authorities and must abide by Federal Reserve bank restrictions.

Shadow banking, on the other hand, refers to any type of lending provided by financial institutions that are not commercial banks and not regulated as banks. Like traditional banks, shadow banks rely on short-term funds to make longer-term loans. That’s where the similarities end. Since shadow banks are not depository institutions, they do not have deposits to lend out to borrowers. Instead, they rely on money from investors for making loans.

The difference? Unlike deposits that are FDIC insured, investor dollars collected through the shadow banking industry are not insured. It seems simple and straightforward, but that simple difference alone creates a major risk for investors and for the entire financial system.

Why do we Need Shadow Banking?

Shadow banking can play a positive role in supporting economic growth by diversifying sources of finance, deepening and broadening the available pool of capital for companies, and lowering funding costs for corporates and banks.

Policy measures to support transparent and simple markets-based finance are desirable to attract investor interest and support the supply of funds, while adequate levels of transparency and investor protection in alternative lending vehicles are necessary to ensure market integrity. Within this sphere, marketplace lending and direct lending from within the asset-management sector may to continue to grow and play an increasingly important role in the provision of credit to the real economy.

If well structured and supported by appropriate policy measures, the shadow banking system can support a variety of investor and corporate needs and enhance the efficient functioning of capital markets.

However, since shadow banking activities have been playing a much bigger role in the financial sector than they did prior to the 2007-2008 financial crisis, proper monitoring of credit flows and systemic risks is fundamental to prevent defaults that would endanger financial stability.

A legislative procedure on a revised prudential framework for investment firms, which would also attempt to address the systemic risk issue of shadow banking, is now being negotiated by EU legislators.

What are the Risks With Shadow Banking?

Unlike regulated banks, shadow banks typically have no direct and explicit access to public sources of liquidity or credit backstops. They are not usually counterparties in central bank operations. This means that shadow banking has only a limited capacity to withstand liquidity pressure and may itself become a catalyst of market turmoil, particularly when it has grown is size and when its difficulties feedback to regulated banks.

Moreover, unlike traditional money, shadow money is constrained by the value of assets that serve as collateral. The underlying secured financing is vulnerable to market shocks. In a crisis the  classical vicious cycle of lower asset prices and lower collateral value would probably be accentuated by two aggravating forces:

• First, collateral values are likely to fall more than asset prices when uncertainty is rising. Indeed, the whole point of collateralized transactions is for the lender to save transaction costs and not have to worry about the exact value of the underlying security. If these worries arise nonetheless they inevitably catch lenders “uninformed” triggering outsized risk premia.
• Second, a decline in collateral values usually translates in additional collateral calls possibly compounded by higher haircuts and margin requirements. This is a tightening of credit conditions and may enforce a reduction in secured lending and leverage, standard conditions for fire sales. The nexus between asset prices and secured lending also easily extends to unsecured lending, including money markets, which means that all systemically important markets could seize up at the same time. Altogether, widespread collateralization establishes links between leverage, asset prices, hedging costs and liquidity across many markets. Trends are mutually reinforcing and can escalate into fire sales and market paralysis.

Regulators fear that shadow banking has been conducive to excessive leverage in the economy and may exert systemic pressure through sudden stops and asset fire sales. Leverage in modern financial systems arises not only from bank balance sheets but also from off-balance sheet transactions that involve banks and other institutions. The latter has grown in importance in the 2010s, is hard to track in official statistics and is probably less stable.

The risk of fire sales is a particular concern in private repurchase operations, the main market for funding of securities holdings. Moreover, distress in collateralized transactions is likely to spill over to regulated banking activity for two reasons.

• First, a large part of the shadow banking system is either owned or funded by regulated banks. Ownership is common for special-purpose vehicles or European asset managers. The funding link is strong to corporates or leveraged funds.
• Second, regulated banks are directly involved in shadow banking through their broker-dealer activities. Even if they act only as intermediaries on a matched-book basis, they still incur risk. For example, in order to achieve collateral efficiency dealer banks engage in re-hypothecation (re-pledging of collateral). And in order to minimize balance sheet usages, they use their scope for netting positions. This means that in case of market distress and collateral value losses, dealer banks face rollover risks, which are not dissimilar to a classical deposit run.

Shadow banking becomes a systemic risk particularly if it grows rapidly relative to other markets and is motivated predominantly by regulatory arbitrage. These risks may end up being “put” to the public safety net, as many shadow-banking-related entities—banks, dealer banks, and (under some conditions) money market funds—benefit from implicit or explicit guarantees. These “puts” make the system effectively subsidized

Can Shadow Banks Create Money?

Shadow banks, like conventional banks undertake various intermediation activities akin to banks, but they are fundamentally distinct from commercial banks in various respects. First, unlike commercial banks, which by dint of being depository institutions can create money, shadow banks cannot create money. Second, unlike the banks, which are comprehensively and tightly regulated, the regulation of shadow banks is not that extensive and their business operations lack transparency.

Third, while commercial banks, by and large, derive funds through mobilization of public deposits, shadow banks raise funds, by and large, through market-based instruments such as commercial paper, debentures, or other structured credit instruments.

Fourth, the liabilities of the shadow banks are not insured, while commercial banks’ deposits, in general, enjoy Government guarantee to a limited extent. Fifth, in the times of distress, unlike banks, which have direct access to central bank liquidity, shadow banks do not have such recourse.

Which Bank is a Shadow Bank?

Plenty of well-known companies are counted as shadow banks. These include:

• Investment banks, like Goldman Sachs or Morgan Stanley
• Mortgage lenders
• Money market funds
• Insurance/re-insurance companies

The shadow banking industry plays a critical role in meeting rising credit demand in the United States. Although it’s been argued that shadow banking’s disintermediation can increase economic efficiency, its operation outside of traditional banking regulations raises concerns over the systemic risk it may pose to the financial system.

The reforms enacted through the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act focused primarily on the banking industry, leaving the shadow banking sector largely intact. While the Act imposed greater liability on financial companies selling exotic financial products, most of the non-banking activities are still unregulated.

The Federal Reserve Board has proposed that nonbanks, such as broker-dealers, operate under similar margin requirements as banks. Meanwhile, outside the United States, China began issuing directives in 2016 directly targeting risky financial practices such as excessive borrowing and speculation in equities.

Why is Shadow Banking Growing?

Shadow banking has grown by leaps and bounds around the world in the last decade. It is now worth over $70 trillion. Many people are worried about institutions that provide credit intermediation, borrow and lend money like banks, but are not regulated like them and lack a formal safety net. The largest shadow banking markets are in the United States and Europe, but in emerging markets, they have also expanded very rapidly, albeit from a low base.

What drives shadow banking? Our analysis shows that shadow banking growth is associated with GDP growth, low interest rates and low term spreads (inducing search for yield), bank capital stringency (capturing regulatory circumvention), and with growth of institutional investors. Controlling for these factors, there also appears to be some complementarity with the size of the banking sector.

Looking forward, the current financial environment remains conducive to further growth in shadow banking. Many indications point to the migration of some activities—such as lending to firms—from traditional banks to the nonbank sector. Especially in the euro area, the growth of lending by shadow banks seems to gather force, while its share of total lending remains high in the United States

How Big is the Shadow Banking System?

In the years since the crisis, global shadow banks have seen their assets grow to about $72 trillion, a 75% jump from the level in 2010, the year after the crisis ended. The asset level is through 2017, according to bond ratings agency DBRS, citing data from the Financial Stability Board.

The U.S. still makes up the biggest part of the sector with 29% or $15 trillion in assets, though its share of the global pie has fallen. China has seen particularly strong growth, with its $8 trillion in assets good for 16% of the total share.

Within shadow banking, the biggest growth area has been “collective investment vehicles,” a term that encompasses many bond funds, hedge funds, money markets and mixed funds. The group has seen its assets explode by 130% to $36.7 trillion. It poses particular danger because of its volatility and susceptibility to “runs” and is part of the “significant risks” DBRS sees from the industry.

Where do Shadow Banks Get Their Money?

In traditional lending, the volume of lending by a bank is linked to the volume of deposits the bank receives and what it can borrow on the markets. Shadow banking works on the same principle. So, for example, an investment fund takes in money from investors, issuing shares in the fund in return. In order to earn a return on the investment for its investors the fund uses this money to buy securities (for example, a bond issued by a country or company).

Just as the bank acts as the “middleman” between savers and borrowers to earn a specified interest rate, the investment fund acts as the channel linking investors and countries/companies to earn an investment return. By raising funds from investors and then lending this money to countries/companies, shadow banking entities act like banks.

An advantage to shadow banking is that it reduces the dependency on traditional banks as a source of credit. This is a positive benefit for the economy because it acts as an additional source of lending, and provides diversification in the financial system.

On the other hand, there is the risk that shadow banking can contribute to too much lending in the economy. This has the potential to lead to a harmful downturn.

Are Insurance Companies Part of Shadow Banking?

Shadow institutions typically do not have banking licenses; they do not take deposits as a depository bank would and therefore are not subject to the same regulations. Complex legal entities comprising the system include hedge funds, structured investment vehicles (SIV), special purpose entity conduits (SPE), money market funds, repurchase agreement (repo) markets and other non-bank financial institutions.

Many shadow banking entities are sponsored by banks or are affiliated with banks through their subsidiaries or parent bank holding companies. The inclusion of money market funds in the definition of shadow banking has been questioned in view of their relatively simple structure and the highly regulated and unleveraged nature of these entities, which are considered safer, more liquid, and more transparent than banks.

Shadow banking institutions are typically intermediaries between investors and borrowers. For example, an institutional investor like a pension fund may be willing to lend money, while a corporation may be searching for funds to borrow. The shadow banking institution will channel funds from the investor(s) to the corporation, profiting either from fees or from the difference in interest rates between what it pays the investor(s) and what it receives from the borrower.

Examples of Shadow Banking

During 1998, the highly leveraged and unregulated hedge fund Long-Term Capital Management failed and was bailed out by several major banks at the request of the government, which was concerned about possible damage to the broader financial system.

Structured investment vehicles (SIVs) first came to public attention at the time of the Enron scandal. Since then, their use has become widespread in the financial world. In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off their balance sheets into special purpose vehicles (SPEs) or similar entities.

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This enabled them to bypass regulatory requirements for minimum capital adequacy ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance was planned to require them to put some of these assets back onto their books during 2009, with the effect of reducing their capital ratios.

One news agency estimated the amount of assets to be transferred at between $500 billion and $1 trillion. This transfer was considered as part of the stress tests performed by the government during 2009.

What is Shadow Debt?

In a move that surprised many experts, bankruptcy filings have significantly dropped during the Covid-19 pandemic. Bankruptcy filings dropped 30% in 2020 and if filings in May 2021 are any indication, 2021 may have another 30% drop. But for every action there is an equal and opposite reaction and delay i filing bankruptcy may come at greater costs for consumers.

Currently, the average consumer is waiting more than 22 months after their first 90 day delinquency notice to file bankruptcy. The average household has a total of $240,000 of debt by the time they file bankruptcy. The delay in filing is increasing household “shadow debt” which is debt that does not appear on credit reports. Think of overdraft fees, nsf check fees, unpaid rents, and certain medical bills. Shadow debt, on average, is rising at a staggering rate of $7,200 per month for households delaying filing bankruptcy.

Instead of delaying the benefits of bankruptcy and the opportunity for a fresh start, consumers should engage in the process early, reap the financial benefits and free up cash flow for their household. The idea that bankruptcy is bad or should be delayed is born from years of corporate propaganda, but the reality is that delaying bankruptcy is usually worse for most households.