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The non-bank financial intermediaries

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The non-bank financial intermediaries

Introduction

The non-bank financial intermediaries can do their banking

operations without following the traditional banking regulations. Market-based

finances such as investment banks, money market funds, mortgage, among other

services, are vital components of shadow banking. Also, shadow banking entails

risky investment products and loan-shark operations that occur between

individuals and business organizations. The shadow banking is a symbol of

economic risks as it may fuel financial instability in the process. The shadow

banks raise short term funds to buy assets in the money markets. Examples of

the assets include mortgages with long term maturities and operate against

traditional banking regulation. The securitization chain runs from the original

mortgage that has been sold and comes back as a security that will be sold to

the initial investors. In banking, shadow institutions do not operate with

banking licenses as opposed to the traditional banks. Hedge funds, SIV, SPE,

and repurchase agreements are some of the complex entities in the shadow

banking regulations. The investors and borrowers are brought together through

shadow banking. This research paper analyses shadow banking, its operations,

potential risks, and its development in the world.

Background

In 2007, Paul McCulley, an economist who was the executive

director of PIMCO, shed light on shadow banking during an annual meeting

(McCulley, 2015). In the United States, the shadow institutions have engaged in

maturity transformation as they offer their services. The financial

institutions use deposits that are short terms to fund long terms loans hence

maturity transformation. The maturity transformation in the shadow banks does

not follow the traditional banking regulation. The shadow banks cannot borrow

emergency funds from the Federal Reserve, and the insurance does not cover the

depositors. These aspects made them be in ”shadows” hence the name shadow

banks. The risks banking brings to the economy the leverage risks. Leverage is

the system where the banks continue increasing while spreading risks to the

economy. The shadows banks are generally leveraged and fuel the risk

characteristic to the economy leading to financial challenges.

The Financial Stability Board (FSB) deals with financial

aspects and supervision of the financial institutions and economies in the

United States. The board defines shadow banks as the entities that operate

outside the regulated banking system. Maturity transformation, leverage, credit

risk transfer, and liquid transformation are vital issues that are used in

shadow banking. The shadows banks are associated with the broker-dealers who do

business operations through the repurchase agreements. In the process, an

investor sells an entity intending to repurchase the security in the future

with a specific price. The Corporate IOUs and mortgage-backed securities are

purchased through the money market mutual funds in the industry and can be

termed as shadow banks.

In the United States, the government has introduced

regulations to control the banks as they have become the backbone of the

financial economy. The government aims to safeguard the people on the savings

they make in the banks. The issue of risk is a concern by the government as the

banks are venturing into different banking activities. To maximize profit and

free regulation, some investors have opted to work through shadows. In the

1970s, the United States was affected by high rates of inflation, and this

prompted the money-market funds to get involved. In 2008, the world witnessed

an economic crisis that affected many countries economically. During the

crisis, the United States did not concentrate much on helping the falling

banks, but it pumped a large amount of money in the shadow-banking system

(Aitken & Singh, 2016). The borrowing from the market funds or the hedge

funds signified danger during this time of crisis. In China, the investors

changed operations to wealth management products hence reaping significant sums

of profits from the economic returns. Fierce lobbying in the banking sector has

hindered the regulation efforts made by the United States Federal Government.

The Chinese government got engaged in peer-to-peer lending to regulate the

operations of the banking systems. For example, the Ponzi scheme attracted

trillions of money, and hence the government needed to set up regulations and

gain economic benefits. Shadow banking is dangerous to any government, and

therefore authorities over the world have been controlling it from the

beginning.

The operations of the shadow banking system

The shadow banks raise short term funds to buy long term

assets in the money markets. When the investors notice that there are no potential

risks to the financial system, they obtain the shadow funds and do their

operations. They get money within a short period and invest in the long-term

maturities for financial gain. The long term assets may pose financial risks,

and investors may withdraw their funds instantly. The shadow banking may be a

problem when the investors tend to withdraw all their funds; hence the

financial institutions will run into difficulties. The real financial banking

institutions may find themselves involved in shadow banking. On some occasions,

the shadow banks are controlled by commercial banks to gain reputation and

reliable like the parent bank. Lack of disclosure by the shadow banking

entities is a common characteristic in the sector.

The shadow banking is characterized by complex shapes and

objects that are within their operations. This makes it difficult to measure

the size of shadow banks as the government does not regulate them. In recent

years, shadow banking has become the most significant form of banking in the

United States. The Federal Government, through the Federal Reserve, has

collected the data on repo lending by the shadow banking system (Adrian &

Shin, 2016). This helps to gain formidable information on the distribution and

development of the shadow banks. The FSB has conducted operations towards the

flow of funds from the source to the end. It keeps off the risks that may occur

through the shadow banking system to the financial system. Also, the FSB is not

involved with leverage or the problems associated with the shadow banking

sector. FSB wants to link the information gained from the shadow banking system

with maturity transformation, liquid transformation, credit transfer, and

leverage activities. Cross border activities have not been factored in the

jurisdiction on the shadow banking system as per the survey conducted by the

FSB (Gorton et al., 2015). The governing authorities need to engage in

collecting and searching for information for the vulnerabilities made by the

shadow banking system. Investigations are also conducted on the traditional

banks getting exposed to the shadow banks, a factor that is likely to have an

impact on the economy. The authorities are coming up with suggestions to

increase the regulation to shadow banks to get vital information on their

operations.

On the contrary, the

shadow banks may get discouraged and keep off so that their data may not be

regulated. Also, the authorities tend to work with shadows to bring together

incomplete data in the system. The incomplete information arises from

activities and entities that make up the shadow banking in their operations.

Benefits of shadow banking

The shadow banking helps to reduce the dependency of

investors and customers on the traditional banks. The shadow banks become an

alternative source of credit; hence banking operations are well streamlined.

With no regulation, one can take advantage of shadow banking to gain enough

returns from its services. The shadow banks can take as much risk as they can

by selling securities. The banks have been affected by regulation hence

minimizing their profits, but shadows banks are opposite. Also, the shadow

banks are not affected by compliance procedures that may cost them; therefore,

take advantage of the situation and win big. The shadow banks have been running

their services run on smoothly due to the given freedom of operations. The

uninsured and uninsurable finances may be taken from traditional banks and

moved to the shadow banking system (Fein, 2015). The shadow banking system is

helpful as it ensures there is financial stability in the country. The shadow

banks help institutional investors by managing large sums of money where there

are deposit insurance problems.

When the traditional banks are distressed, the additional

credit in the sector may be provided through shadow banking. The traditional

banks have always oppressed the small companies operating with little capital.

The shadow banks are a solution to these companies as they seek to expand their

operations. The hedge funds, equity funds and other types of funds are vital in

giving out loans on the risky areas. The shadow banks pose better flexibility

in terms of lending as compared to traditional banks. The access of the loan

funds from the shadow banks is also made suddenly, and hence operations are

easily facilitated. Due to the intense regulatory scrutiny in the United

States, the shadow banks have become the focus of the investors and customers.

When the financial crises occur in the country, the shadow banks may be an

option to add their economic value. Financial stability and growth can be

ensured through liquidity transformation leading to liquid securities. The

willing investors take advantage of shadow banking and invest in marketing risk

securities. The inherently unstable processes may be used to shut down the

risks that occur and provide a solution to the economy.

The people in society need money to develop themselves

economically. Shadow banks serve as an easy way of gaining funds; hence they

are not regulated. Safe and liquid securities are urgently required in the

economy as the people make increased demand for funds. The supply of funds from

traditional banks is limited and cannot satisfy the market from the people in

the United States (Gennaioli et

al., 2016). In the United States,

the shadow banking system is utilizing the money market funds, repurchases and

asset commercial paper to win a large number of people.

The shadow banking ensures there is liquidity expansion,

and there are low costs in the firms. This results in higher economic growth as

investments attract many people. The shadow banks allow the funding of risk

assets and hence helpful during tough economic times in the country. Also, the

right balance is ensured through excessive risk-taking in the investment, thus

facilitating an alternative source of funds. The shadow banks serve as

alternative solutions through stable liquidity as there may be limitations in

the traditional banks.

Risks associated with

shadow banking

Unlike the traditional banks, the shadow banks are not

regulated and do not have a connection with central bank operations. This means

they do not withstand the liquidity pressure that may occur in the financial

market. It may fuel market turmoil when it has grown in size and problems are

taken back to the traditional banks. There may arise issues of operations, and

asset fire as the shadow banks operate on excess leverage in the banking sector.

Also, shadow banking has been involved in fuelling the economic crisis in the

United States. The shadow banks have been lending funds to borrowers whose

creditworthiness does not qualify. This is against the banking policies, and

the shadow banks have taken the change of having not been registered. The

shadow banks have also been financing the collapsed mortgages with a lot of

funds.

The security of investors’ funds with the shadow

banks is limited. This is because the shadow banks do not receive backups from

the Federal Reserve System in the United States (Doyle et al.,

2016). When the shadow banks are in financial crises, the investors are likely

to suffer. Moreover, the shadow banks will endure when all the investors opt to

withdraw all their funds, leaving them to run on empty hands. The shadows banks

receive considerable risks in their operations as well as themselves posing

substantial risks to the economy. The shadow banks encounter the same risks as

the traditional banks, but the latter is secure when the risk of failure

arises. The shadow banks may be affected by the distressed sale. This occurs

when the investors are worried about the operations of the shadow banks, and

their long term assets are liquidated. This will leave the shadow banks with no

long term assets to buy. The long term assets may start trading at lower market

value due to the increased supply leading to distressed sales (Ghosh et al.,

2017). In the shadow banking, the perceived losses may, in turn, change to

actual damages during their operations.

In the year 2008, there was a meltdown that resulted from

the shadow banks being bailed out by the traditional banks. The conventional

banks were acting in that manner to maintain their reputation in the financial

markets. This makes the traditional banks have an advantage over the shadow

banks while managing their future operations.

The shadow banking in

the world

The shadow banking has been growing over many parts of the

world. It has gained an advantage of the regulations that are characterized by

traditional banks. Investors over the world have seen shadow banking as an

alternative funding institution where funds can easily be acquired. Countries

such as China have their eyes on the shadow banking in markets while weighing

it with the policymaking system. A survey on the market coverage conducted in

the year2016 shows that the United States is leading in shadow banking. The

other countries that follow are the United Kingdom, China, Ireland, and Germany

in that order.

In 2008, the United States suffered economic crises that

derail its banking operations. It led to unemployment to many Americans leading

to family break ups. Private banks and hedge funds led the economic depression.

The collapse of the shadow banking in 2008 helped the country to regain its

economy during the crisis. Despite the threat in 2008, shadow banking is

increasing rapidly in the United States. They have played a central role in

fueling the present financial crises hence economic risks. The lending

conditions to the underqualified people in the economy does not make the

government of the United States happy as credit conditions are ruined. The

shadow banks have their assets grown to $52 trillion in recent years, making a

vast improvement from the past (Cox, 2020). Out of the $52 trillion, the United

States accounts for 26% in assets. The United States will come up with

thorough measures in the future that will help in controlling the growth of

shadow banks.

China has been affected by shadow banking on its financial

stability. The estimates of data of shadow banking in China has been

complicated. In June 2016, it was estimated that 58.3 trillion Yuan to comprise

the shadow banking (“Shadow banking in China: a looming shadow”,

2020). The growth rate of shadow banking in China is around 30% per year, and

this figure is higher than the average world growth.

China: the size of the

shadow banking

In the United Kingdom, shadow banking has also been growing

in its economy. The percentage of shadow banking in the United Kingdom is

almost similar to that of China. The FSB figures show that around 11% of the

banking sector in the United Kingdom is controlled by shadow banking. The banks

in the United Kingdom are exposed to shadow banking activities. These

activities account for 2%, and the government has come up with measures to

limit the activities. The issue of shadow banking may not be a big concern as

compared to the recent Brexit that has altered the European market. The effect

of Brexit is likely to increase the activities of shadow banking in the United

Kingdom.

According to research, shadow banking has grown rapidly in

Ireland. In the year 2017, it was estimated 2.3 trillion pounds assets were

owned by the shadow banking system (“Explainer – What is shadow

banking?”, 2020). The shadow banking system in Ireland is made up of money

markets, investment funds and other financial entities. The FSB estimates

shadow banking to be growing moderately in Germany. In the year 2017, the

estimated value of the shadow banking was $1.7 billion and an annual growth

rate of around 6% (“Global shadow banking system | Deloitte

Deutschland”, 2020). The shadow banking in Germany comprises of collective

investment vehicles through insurances. Other activities in the shadow banking

include consumer finance and automobile funds.

Conclusion

To sum up, market-based finances such as investment banks, money market funds, mortgage, among other services, are vital components of shadow banking. The shadow banking is a symbol of economic risks as it may fuel financial instability in the process. The shadow banks raise short term funds to buy assets in the money markets. The financial institutions use deposits that are short terms to fund long terms loans hence maturity transformation. The maturity transformation in the shadow banks does not follow the traditional banking regulation. Maturity transformation, leverage, credit risk transfer, and liquid transformation are vital issues that are used in shadow banking. The shadows banks are associated with the broker-dealers who do business operations through the repurchase agreements. When the investors notice that there are no potential risks to the financial system, they obtain the shadow funds and do their operations. The shadow banking helps to reduce the dependency of investors and customers on the traditional banks. With no regulation, one can take advantage of shadow banking to gain enough returns from its services. Unlike the traditional banks, the shadow banks are not regulated and do not have a connection with central bank operations. This means they do not withstand the liquidity pressure that may occur in the financial market. Finally, the research paper has analyzed shadow banking, its operations, potential risks, and its development in the world.

 

 

 

 

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