In September 2015, Reuters reported that several central bankers attending a conference in Paris cautioned that imposing bank regulatory requirements on non-banks, or shadow banks, could have some unintended consequences for the financial markets. In this article, we will use some of the foundational concepts from the Investment Foundations course of study to explain the role that shadow banking plays in the global financial system.

Shadow Banking: Overview

A fundamental role of the investment industry is to help savers invest their money and to help spenders raise capital in the financial markets. In this role, the investment industry contributes to the efficient allocation of resources in the economy.

Banks also help savers invest their money and spenders raise needed money. Banks collect deposits and transform them into loans to borrowers. Shadow banks similarly gather money from investors and provide money to corporations that need it for investments in such things as equipment and inventory. These transactions occur outside of the regular banking system and are not subject to the same regulatory oversight as banks, hence the name shadow banks. These transactions may be referred to as market-based financing or non-bank financing. After the financial crisis of 2008, tightened regulations reduced banks’ lending capacity and shadow banking became an increasingly important source of funds for corporate enterprises.

The amounts of the transactions conducted through shadow banking are difficult to measure. Using a broad definition of shadow banking, the Financial Stability Board (FSB) estimates the size of the shadow banking sector globally to be approximately $75 trillion as of the end of 2013. Using a narrower definition of shadow banking, the FSB estimate is about $50 trillion. Almost 80% of shadow banking transactions occur in the United States, United Kingdom, and five countries in the euro area (France, Italy, Germany, the Netherlands, and Spain).

Given the size of the market, shadow banking may be a source of systemic risk, but the nature of the market itself makes it difficult to measure and control.

Shadow Banking: The Basics

Investment companies originated the shadow banking system by offering savers financial products with higher interest rates (returns), such as money market funds, as an alternative to deposits in banks. The investment company then lent the money raised to borrowers. The shadow bank process is considered to be “bank-like” because it typically receives short-term money and makes longer-term loans.

Shadow banks differ from traditional commercial banks in three key ways: (1) shadow banks (as non-banks) are not subject to banking regulations, such as the rules about the amount and type of capital required; (2) deposits into shadow banks are not insured/guaranteed by government; and (3) shadow banks are not able to borrow from the central banks.

Risks of Shadow Banking and Regulatory Developments

Shadow banking is interconnected with the traditional banking system by more than accessing the same pool of savers. For example, money market funds are large holders of bank-issued commercial paper: According to data from the European Commission, in 2013, money market funds allocated approximately 85% of their assets to securities issued by banks. Money market holdings accounted for approximately 38% of the short-term debt issued by banks.

The asset management sector has also increased its role in the provision of credit. For example, some private equity funds provide loans to borrowers traditionally serviced by banks. Funds may specialize in small business lending, real estate loans, equipment financing, and factoring (financing invoices and receivables). Some funds also invest in debt obligations that have been originated or issued by peer-to-peer lending platforms, such as UK-based Zopa and the Lending Club in the United States.

As part of ongoing financial reform efforts, policymakers around the world are developing measures to regulate shadow banking. These efforts have been focused on creating more standardized, transparent, and simpler financing structures as well as safer investment vehicles. These policy initiatives are being led at the global level by the FSB and are supported by the development of country-specific regulations.

The Bottom Line

Without the funds offered by shadow banks, many corporate enterprises would not be able to finance their long-term goals. Shadow banking can play a positive role in supporting economic growth by diversifying sources of finance, expanding the available pool of capital for companies, and lowering funding costs for both corporations and banks. If well structured and supported by appropriate risk-mitigating measures, the shadow banking system can support a variety of investor and corporate needs and enhance the efficient functioning of the global financial system.