shadow banking, its operations, potential risks, and its development in the world

 shadow banking, its operations, potential risks, and its development in the world

Introduction

The non-bank financial intermediaries can do their banking operations without following the traditional banking regulations. Market-based finances such as investment banks, money market funds, mortgage, among other services, are vital components of shadow banking. Also, shadow banking entails risky investment products and loan-shark operations that occur between individuals and business organizations. The shadow banking is a symbol of economic risks as it may fuel financial instability in the process. The shadow banks raise short term funds to buy assets in the money markets. Examples of the assets include mortgages with long term maturities and operate against traditional banking regulation. The securitization chain runs from the original mortgage that has been sold and comes back as a security that will be sold to the initial investors. In banking, shadow institutions do not operate with banking licenses as opposed to the traditional banks. Hedge funds, SIV, SPE, and repurchase agreements are some of the complex entities in the shadow banking regulations. The investors and borrowers are brought together through shadow banking. This research paper analyses shadow banking, its operations, potential risks, and its development in the world.

Background

In 2007, Paul McCulley, an economist who was the executive director of PIMCO, shed light on shadow banking during an annual meeting (McCulley, 2015). In the United States, the shadow institutions have engaged in maturity transformation as they offer their services. The financial institutions use deposits that are short terms to fund long terms loans hence maturity transformation. The maturity transformation in the shadow banks does not follow the traditional banking regulation. The shadow banks cannot borrow emergency funds from the Federal Reserve, and the insurance does not cover the depositors. These aspects made them be in ”shadows” hence the name shadow banks. The risks banking brings to the economy the leverage risks. Leverage is the system where the banks continue increasing while spreading risks to the economy. The shadows banks are generally leveraged and fuel the risk characteristic to the economy leading to financial challenges.

The Financial Stability Board (FSB) deals with financial aspects and supervision of the financial institutions and economies in the United States. The board defines shadow banks as the entities that operate outside the regulated banking system. Maturity transformation, leverage, credit risk transfer, and liquid transformation are vital issues that are used in shadow banking. The shadows banks are associated with the broker-dealers who do business operations through the repurchase agreements. In the process, an investor sells an entity intending to repurchase the security in the future with a specific price. The Corporate IOUs and mortgage-backed securities are purchased through the money market mutual funds in the industry and can be termed as shadow banks.

In the United States, the government has introduced regulations to control the banks as they have become the backbone of the financial economy. The government aims to safeguard the people on the savings they make in the banks. The issue of risk is a concern by the government as the banks are venturing into different banking activities. To maximize profit and free regulation, some investors have opted to work through shadows. In the 1970s, the United States was affected by high rates of inflation, and this prompted the money-market funds to get involved. In 2008, the world witnessed an economic crisis that affected many countries economically. During the crisis, the United States did not concentrate much on helping the falling banks, but it pumped a large amount of money in the shadow-banking system (Aitken & Singh, 2016). The borrowing from the market funds or the hedge funds signified danger during this time of crisis. In China, the investors changed operations to wealth management products hence reaping significant sums of profits from the economic returns. Fierce lobbying in the banking sector has hindered the regulation efforts made by the United States Federal Government. The Chinese government got engaged in peer-to-peer lending to regulate the operations of the banking systems. For example, the Ponzi scheme attracted trillions of money, and hence the government needed to set up regulations and gain economic benefits. Shadow banking is dangerous to any government, and therefore authorities over the world have been controlling it from the beginning.

The operations of the shadow banking system

The shadow banks raise short term funds to buy long term assets in the money markets. When the investors notice that there are no potential risks to the financial system, they obtain the shadow funds and do their operations. They get money within a short period and invest in the long-term maturities for financial gain. The long term assets may pose financial risks, and investors may withdraw their funds instantly. The shadow banking may be a problem when the investors tend to withdraw all their funds; hence the financial institutions will run into difficulties. The real financial banking institutions may find themselves involved in shadow banking. On some occasions, the shadow banks are controlled by commercial banks to gain reputation and reliable like the parent bank. Lack of disclosure by the shadow banking entities is a common characteristic in the sector.

The shadow banking is characterized by complex shapes and objects that are within their operations. This makes it difficult to measure the size of shadow banks as the government does not regulate them. In recent years, shadow banking has become the most significant form of banking in the United States. The Federal Government, through the Federal Reserve, has collected the data on repo lending by the shadow banking system (Adrian & Shin, 2016). This helps to gain formidable information on the distribution and development of the shadow banks. The FSB has conducted operations towards the flow of funds from the source to the end. It keeps off the risks that may occur through the shadow banking system to the financial system. Also, the FSB is not involved with leverage or the problems associated with the shadow banking sector. FSB wants to link the information gained from the shadow banking system with maturity transformation, liquid transformation, credit transfer, and leverage activities. Cross border activities have not been factored in the jurisdiction on the shadow banking system as per the survey conducted by the FSB (Gorton et al., 2015). The governing authorities need to engage in collecting and searching for information for the vulnerabilities made by the shadow banking system. Investigations are also conducted on the traditional banks getting exposed to the shadow banks, a factor that is likely to have an impact on the economy. The authorities are coming up with suggestions to increase the regulation to shadow banks to get vital information on their operations.

On the contrary, the shadow banks may get discouraged and keep off so that their data may not be regulated. Also, the authorities tend to work with shadows to bring together incomplete data in the system. The incomplete information arises from activities and entities that make up the shadow banking in their operations.