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.