Understanding Shadow Banking
Shadow banking, also known as the parallel financial system, refers to a set of financial activities that take place outside the traditional banking regulatory framework. These activities include lending, financing and similar transactions. Understanding this concept is essential, as it plays an important role in the global economy.
What is Shadow Banking?
Shadow banking is a network of non-bank financial entities that offer credit and financing services, but are not subject to the same regulation as traditional banks. This means that they are not subject to the same capital, liquidity and transparency requirements. Investment funds, pension funds, peer-to-peer lending companies and hedge funds are all examples of shadow banking entities.
Here are a few examples of entities that fall into this category:
- Hedge funds: These funds use non-traditional management techniques to generate absolute returns through aggressive strategies. They are often speculative in nature, and use leverage to boost the return on invested capital.
- Securitization funds: This technique of transferring receivables or assets held by a bank (or other financial institution) to a securitization mutual fund, which then sells them on to investors, continues to flourish. Securitization operations totaled $652 billion in outstandings at the start of 2020.
- Money market funds: These are invested in short-term receivables, government and corporate securities (treasury bills, bank certificates of deposit, commercial paper, etc.). According to figures from theEuropean Fund and Asset Management Association (Efama), these money-market (and cash) funds accounted for +/- 6% of the 24,900 billion in assets under management in Europe.
- Bond funds mainly invested in corporate or government bonds.
How does it work?
Shadow banking entities are involved in credit, lending and investment transactions, providing alternative financing solutions. Unlike traditional banks, they do not collect deposits from the public, but obtain funds from other sources such as financial markets or institutional investors. They thus offer a diversity of financial products and services that can complement or compete with those of banks.
Danger of Shadow Banking
The main problem caused by shadow banking is its interaction with the traditional financial system. The collapse of an entity involved in this shadow business can lead to the collapse of the traditional banking system. There are precedents for this. Take, for example, the subprime crisis (2007/2008), which began with the collapse of the American bank Lehman Brothers, before spreading to all the agents involved in this trading.
