What Is Shadow Banking And Why Does It Exist?

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CryptoMode Shadow Banking

Most cryptocurrency enthusiasts are keen to learn more about the finance industry. However, one crucial concept that is often ignored is shadow banking. It is a very real system and one that makes money printing through traditional banking seem like chump change. 

An Overview Of Shadow Banking

Financial institutions come in many different forms, shapes, and sizes. Although it seems most of them must adhere to strict regulations, that is not necessarily the case. Un-traditional institutions do not accept traditional deposits, therefore bypassing regulatory red tape as it does not apply to them. It may seem strange to let such providers exist in an unregulated manner, yet that is an absolute necessity in the financial industry. Moreover, it makes one wonder why governments insist on regulating Bitcoin when they don’t even do so for shadow banking institutions.

Service providers in the shadow banking segment are innovators in financial markets. The term “shadow” has a negative connotation to it – and for a good reason, as we will explain later, yet it has some benefits. The lack of regulatory oversight grants some leeway for these institutions to finance lending. For instance, these providers do not need to meet capital reserves and liquidity.

One benefit to the lack of oversight is pursuing more considerable risks without too many drawbacks. That applies to credit, liquidity, and overall market risks. By extension, these are the institutions that helped fuel the subprime mortgage lending and loan securitization markets through their lending activities in the nillies. We all know that ended with the financial crisis of 2008, spotlighting the shadow banking institutions and how they over-extended credit and systemic risk. 

How Big Is This Industry?

Sadly, there is no straightforward answer to that question. Shadow banking encompasses every non-bank financial institution that isn’t subject to regulatory overview. As no one regulates these providers, it is nearly impossible to tell how many of them exist today. Institutions range from money market funds to investment banks, hedge funds, payday lenders, and insurance companies, among others. 

One would expect the increasing scrutiny since 2008 to have a meaningful impact. That is not the case whatsoever. Instead, it has facilitated even more immeasurable growth in this industry. An estimate, presented in a 2018 Financial Stability Board report, recorded $92 trillion in assets in 2015. Additionally, shadow banking assets posing financial stability risks rose to $34 trillion. Keep in mind none of these findings include data from China for rather obvious reasons. 

A prevalent aspect of shadow baking is the use of collateralized loans and repurchase agreements. Those vehicles facilitate short-term lending between players in this shadow world. Moreover, lenders that do not qualify as a bank represent a significant share of mortgages in various nations, including the U.S. Peer-to-peer lending – not the decentralized finance version – is another crucial vertical. 

Keeping A Lid On Shadow Banking

One may think there is a strong incentive for new players to enter the shadow banking realm. After all, there is no regulation and very few restrictions. Moreover, the industry’s growth keeps economies afloat in most parts of the world today. Decoupling shadow banking from traditional finance is not advised, despite the systemic risk it poses. However, it is the – only? – viable solution in centralized finance to meet rising credit demand. 

Even the Dodd-Frank Reform of 2010 has done little to put a lid on this dark side of the finance industry. Policymakers mainly drafted the Reform to address bad behavior in regulated banking. Although it had some minor consequences for non-bank financial institutions, it did not diminish growth in the slightest. To this day, there is still a huge lack of oversight regarding shadow banking. Unfortunately, it seems that it will stay this way, further enhancing the systemic risk for everyone. 

Chinese officials have taken a slightly harsher stance on non-banks since 2017. A crackdown on risky financial products and services is a step in the right direction. However, the shadow side of banking is a vast industry spreading its tentacles in all directions. Eliminating it entirely will prove detrimental to the economic prospects of any country. In essence, shadow banking is too big to fail, which is not necessarily a good outlook. 


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