It’s time for policymakers to help shadow banking emerge from the darkness

Rhodri Preece
There are parts of the shadow banking system that are mostly unregulated (Source: Getty)
The term “shadow banking” was first coined in 2007 to describe parts of the financial intermediation process conducted outside the commercial banking system. It encompasses all non-bank credit intermediation, and spans wholesale markets-based finance (such as certain types of investment funds and securitisation vehicles, as well as activities such as securities financing transactions) and alternative lending channels.

The negative connotations associated with the name stem from the role of complex, opaque and lightly regulated financing activities in the 2008 financial crisis. Shadow banking was thus seen as a source of systemic risk that required containment.

Seven years later, the shadow banking debate has changed dramatically: with traditional bank lending constrained by more stringent regulatory capital and liquidity requirements, the focus on shadow banking has shifted from containing risks to enabling capital markets to revive economic growth.

A new CFA Institute study on shadow banking suggests that non-bank credit in the form of markets-based finance can provide a potential solution to reviving the real economy by helping to channel capital to productive enterprises. But in order to put shadow banking on a sustainable footing, it is necessary to increase standardisation and simplification of issuance structures, as well as boosting transparency more generally, to support investor interests.

The scope of regulation surrounding markets-based finance is already quite broad. In the EU and the US, for example, regulation of investment funds marketed to retail investors is comprehensive, while new rules for money market funds have been established. In this context, the term “shadow banking” is somewhat misplaced. These are not necessarily unregulated activities.

There are other parts of the shadow banking system that are mostly unregulated, however, such as peer-to-peer lending, microfinance companies, trust-based loan provision, and other alternative lending channels, and it is in this domain that risks to investor protection are most likely to emerge.

The renewed interest in shadow banking coincides with the European Commission’s initiative to establish a Capital Markets Union (CMU). The objective of CMU is to tackle barriers to the flow of capital in Europe and to diversify sources of finance for companies. The initiative comes against a backdrop of weak growth and concomitantly accommodative central bank policies. With constrained bank lending, expanding the pool of capital available to European companies is arguably more important than ever. Shadow banking can play a pivotal role in unlocking capital markets, better connecting investors with the financing needs of the economy.

To realise the potential benefits of shadow banking, policymakers must tackle product and market fragmentation within securitisation markets by incentivising more simplified, standardised issuance structures, as well as implementing a more robust framework regarding the use of collateral associated with securities financing. By doing so, shadow banking can support a variety of investor needs and enhance the efficient functioning of the financial system.

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