Shadow banking refers to a range of financial activities carried out by entities that are not subject to the same strict regulations as traditional banks. These players in the financial system operate outside the framework of traditional banks, but provide similar services, particularly in terms of credit and liquidity. The term “shadow” should not be confused with illegal practices, but rather with the fact that these activities take place outside traditional banking regulation.

Characteristics of shadow banking

The shadow banking system includes a variety of institutions and activities such as :

• Money market funds: These funds invest in short-term money market instruments, and their role is similar to that of banks in terms of liquidity management.
• Hedge funds: These speculative investment funds can offer short-term loans or financing to companies or other financial institutions.
• Non-bank finance companies: These entities lend to businesses or consumers, but are not subject to the same reserve requirements as banks.
• Securitization vehicles: Banks and other financial institutions create complex financial vehicles, such as asset-backed securities, to transform illiquid assets (such as mortgages) into tradable instruments.

These activities make it possible to raise capital and provide credit without the institutions concerned being subject to the capital and liquidity requirements imposed on banks by financial regulators. As a result, shadow banking can offer a more flexible and cheaper source of financing, but also entails greater risks.

Advantages of shadow banking

Shadow banking plays an important role in the global financial system, offering several advantages:

1. Complementing traditional banks: Shadow banking entities provide alternative financing to businesses and households, which can increase the overall efficiency of the financial system and diversify credit sources.
2. Financial innovation: The shadow banking sector often enables innovations in financial instruments, making the system more flexible and adaptable to the needs of companies and investors.
3. Reduced dependence on banks: Companies can use these non-bank players to obtain financing without going through traditional banks, which can be particularly useful in times of banking crisis.

Risks associated with shadow banking

However, shadow banking also poses a number of risks to the global financial system:

1. Lack of strict regulation: Shadow banking entities are not subject to the same prudential rules as banks (such as capital, liquidity or reporting requirements). This can make the system more vulnerable to liquidity crises or bankruptcies of financial entities.
2. Contagion risks: Although shadow banking is not directly linked to traditional banks, there can be significant interconnections between the two systems. For example, a crisis in the shadow banking sector can spread to traditional banks via shared loans or financial instruments, amplifying systemic risks.
3. Low transparency: As shadow banking players are not regulated as rigorously as banks, there is less transparency about their activities. This makes it more difficult for regulators and investors to monitor and assess the potential risks associated with this sector.
4. Procyclicality: Shadow banking tends to amplify economic cycles. During periods of growth, credit is often abundant, which can fuel financial bubbles. On the other hand, during periods of crisis, the rapid withdrawal of liquidity in this sector can exacerbate economic recessions.

Shadow banking and the 2008 financial crisis

The role of shadow banking came into sharp focus during the 2008 financial crisis. Prior to the crisis, much of the credit in the US economy was issued by non-bank entities via complex financial instruments, such as mortgage-backed securities (MBS) and other derivatives. When the housing market collapsed, these instruments lost much of their value, triggering a liquidity crisis in the shadow banking system.

The crisis revealed that shadow banking had become too large and risky, while being poorly regulated. As a result, the world’s financial authorities began to pay increased attention to this sector, and to draw up new rules to better monitor and regulate some of its activities.

Post-crisis regulation and reform

Following the 2008 financial crisis, efforts were made to better regulate certain aspects of shadow banking. Among the measures adopted :

• Enhanced transparency requirements: Regulators have demanded greater supervision of certain shadow banking activities, notably securitization and derivatives, and better risk measurement.
• Reducing leverage: Rules to limit excessive leverage among shadow banking players have been introduced to avoid liquidity crises similar to those of 2008.
• Increased oversight: Financial authorities, such as the Financial Stability Board (FSB), are closely monitoring the development of shadow banking to identify new vulnerabilities and adapt regulations accordingly.