Shadow banking represents a sector within the financial ecosystem that carries out bank-like activities, specifically lending, but is not governed by the same regulatory standards put forth for traditional banking systems. Commonly referred to as non-bank financial intermediation or market-based finance, this part of the financial sphere is comprised of institutions which act as the intermediary between investors and borrowers. Providing a source of credit which contributes to financial inclusion, they play a role in facilitating liquidity within the system. The concept of ‘shadow banking’ first surfaced in 2007, introduced by Paul McCulley.
The Composition of the Shadow Banking Sector
Shadow banking encompasses a range of institutions and entities, all of which serve the purpose of providing an alternative to traditional banks for lending transactions. Some of the main types of shadow lenders include Special Purpose Entities, Hedge Funds, and Non-Banking Financial Companies (NBFCs) among others. These bodies offer different investment opportunities and borrowing alternatives, creating diversity in the market and catering to different segments of the population.
The Role of Shadow Banking in Financial Inclusion
The primary function of shadow banking entities is to provide credit. This service plays a crucial part in promoting financial inclusion. The availability of credit from non-traditional sources broadens the accessibility of financial services, fostering an environment that allows for increased financial participation from sectors of the population that may typically be underserved by conventional banking institutions.
Factor of Systemic Risk
However, as demonstrated by the 2008 financial crisis, shadow banking has the potential to generate systemic risk to the broader banking system. This risk can manifest directly or be conveyed via the interconnectedness of partially regulated entities with the mainstream banking system. In other words, the threats posed by the activities and operations of shadow banking entities can impact the overall stability of the global banking system.
| Year | Event | Impact on Shadow Banking |
|---|---|---|
| 2007 | Introduction of the term ‘Shadow Banking’ | Highlighting a new sector within the financial ecosystem |
| 2008 | Global Financial Crisis | Exposure of systemic risks posed by shadow banking |
| 2018 | Liquidity crisis with Indian NBFC, IL&FS | Revived attention to risks within shadow banking |
Regulations and Control Measures
In the wake of the financial crisis of 2008, central banks across several nations such as the USA, Britain, and the European Union have initiated measures to more stringently regulate shadow banking. Similarly, in India, following a liquidity crisis within Non-Banking Financial Company IL&FS in 2018, regulators are revisiting policies surrounding shadow banking. This has led to a renewed focus on understanding and mitigating the potential risks this sector presents to the broader banking system. These measures aim to establish a more robust oversight mechanism intended to prevent future crises.
