The Unregulated World of Shadow Banking

China has a system of its own
By Heide B. Malhotra
Heide B. Malhotra
Heide B. Malhotra
August 7, 2013 Updated: August 7, 2013

The term “shadow banking system” sounds like an opaque and borderline illegal activity. Yet, the name coined by economist Paul McCulley, merely describes nontraditional banking activities that are less regulated and therefore more dangerous than traditional banking.

The shadow banking market is comprised of unregulated nonbank financial intermediaries, such as money market mutual funds, hedge funds, private equity groups, and nonbank mortgage lenders. They do not deal with traditional bank deposits, do not have access to liquidity provided by the Federal Reserve’s discount window, or insurance available from the Federal Deposit Insurance Corporation (FDIC).

They invest in long-term and more illiquid funds, such as mortgages and other debt instruments. As intermediaries between borrowers and lenders, shadow-banking entities depend on short-term funding offered through secured lending and other channels. A very common transaction in the shadow-banking world is the so-called repurchase agreement or repo, where the borrower hands over collateral to the lender. The repo then specifies when the collateral will be bought back by the borrower and what rate of interest the lender receives.

Big players in the shadow banking system include mutual fund companies such as Fidelity Investments and the Vanguard Group, brokers such as Charles Schwab, Goldman Sachs Asset Management, as well J.P. Morgan Asset Management, and hedge funds such as Soros Fund Management LLC and Bridgewater Associates.

Run on Shadow Banking System Still Possible

Despite the size of the players in the shadow banking system, the system has many problems due to “reliance on short-term liabilities to fund illiquid long-term assets, [which] is an inherently fragile activity that can make the shadow banking system prone to runs,” according to a July 2010 report by the Federal Reserve Bank of New York.

“The 2008 financial crisis displayed characteristics of a classic bank run, but people holding bank accounts weren’t the ones scrambling to get their cash. It was lenders demanding their money from other financial institutions,” a December 2011 Wall Street Journal article states. It was an institutional bank run.

The shadow banking system’s debt grew rapidly before 2007 and aggravated the 2008 financial meltdown. The run on these institutions began when liquidity dried up and investors became concerned about solvency and pulled out there money. It was like with blood in the human body: The money in the system stopped flowing. The more money investors withdrew, the more the banks solvency was threatened.

Later, trust in the system completely disappeared, resulting in the institutional bank run, which started in mid-2008. As a result, some of the shadow banking system participants like Lehman Brothers and Bear Stearns went under.

Future Regulation of the Shadow Banking System

Given the recent history, shadow banks’ vulnerability to problems such as bank runs was addressed in 2010 by G-20 leaders, the finance ministers and Central Bank governors of the world’s top 20 economies. They took steps to address regulatory gaps, asking the U.S. Financial Stability Board (FSB) to partner with international regulatory institutions to develop an oversight and regulatory framework.

In November 2012, the FSB published three reports dealing with the shadow banking system, including a report about the need to strengthen the monitoring system.

The fundamental rationale for a monitoring system is that “credit through nonbank channels can have advantages, [but] such channels can also become a source of systemic risk, especially when they are structured to perform bank-like functions … and when their interconnectedness with the regular banking system is strong,” according to the FSB’s monitoring report.

Reducing Size Reduces Risk

Despite the risks inherent in an unregulated shadow banking market, it has become too large to get rid of completely. In addition, many experts state that it does play an important role as an intermediary in the financial sector. This market provides an alternate source of funding and liquidity to corporations, municipalities, and others.

The IMF states that it is difficult to estimate the size of the shadow banking market since many of its members do not report their activities to regulatory authorities.

However, the FSB has shown that the market’s size can be estimated by using the flow of funds data published by the Federal Reserve, as well as other indirect indicators.

According to the FSB, the global shadow banking market accounted for $26 trillion in financial assets in 2002, growing to $62 trillion by 2007. In 2008, during the financial meltdown, the market contracted by $3 trillion to $59 trillion, and then increased by $8 trillion to $67 trillion in 2011.

Shadow banks accounted for 27 percent of the world’s financial intermediaries in 2007, but that number shrank to about 25 percent between 2009 and 2011 due to the financial crisis. However, shadow banks’ own about 50 percent of the world’s bank assets.

The U.S. shadow banking market shrank from 44 percent of the global market in 2005 to 35 percent in 2011. However, with $23 trillion in assets, it was still the largest global shadow banking market in 2011.

China’s Market Different

The size of the global shadow banking market, including the U.S. shadow banking market, can be approximated using indirect financial calculations. But the Chinese system lacks the elements to develop a good estimate, according to a 2013 Federal Reserve Bank of San Francisco report.

Most outside estimates put the size of China’s shadow banking market in 2012 somewhere between $2.2 trillion and $4.8 trillion.

A recent report from Beijing’s Central University of Finance and Economics states that the size of China’s shadow banking system amounted to $3.2 trillion in December 2012 and grew to $3.9 trillion by May of this year.

The Chinese system consists of direct credit extension by nonbank financial firms, such as trust and brokerage companies, which often may be partially or fully owned by China’s state-owned banks. Large Chinese state-owned firms, when lending to small- and medium-sized private companies, are counted among the shadow banks.

“The recent acceleration in China’s shadow banking sector is a direct consequence of tightened regulation and supervision of commercial banks following the global financial crisis,” states the Federal Reserve Bank of San Francisco report.

Default and Legal Risks Biggest in China

The Chinese shadow banking system is unlike its counterparts in developed markets. Its size can only be broadly estimated. Secrecy and transparency issues are at the core of the Chinese system, especially given that the Chinese state tightly controls most aspects of China’s financial markets.

The dissimilarity also applies to shadow banking market risks. In the United States, risks include a maturity mismatch if there is not enough cash available to pay for existing obligations. Also, a risk exists if a company has more debt than paid-in capital and retained earnings. Lastly, the complexity of the local financial markets may not be understood.

The Chinese shadow banking market is comprised of four risks. For example, there is a risk that the issuer of a bond may be unable to pay principal and interest on time. Also, a bank or firm may not have sufficient cash on hand to pay its obligations. A third risk is the legal risk that results when a contract is not enforceable, and lastly, a transaction may not be enforceable due to prohibitions in the regulatory environment.

Shadow Banking Here to Stay

Despite the risks inherent in an unregulated system, the shadow banking market provides corporations and other customers with a source of funding and liquidity, not otherwise available. Thus, it will continue to function outside the regular banking system.

Developed markets’ shadow banking systems have shrunk since the onset of the financial crisis, though they have not disappeared. These banks are not regulated, making them more risky than normal banks. Because of the risks, greater regulation of the shadow banking system is being discussed globally, and the FSB has made recommendations that would strengthen oversight and regulation.

China’s shadow banking market on the other hand lacks even the most fundamental structure and is different from that in developed markets in terms of its composition, players, and drivers. The control, even if unregulated, is in the hands of the Chinese Communist state.

Heide B. Malhotra
Heide B. Malhotra