I wonder if you guys have heard about what ‘shadow banking’ is. In a dictionary, shadow banking is explained as follows; a collection of non-bank financial intermediaries that provide services similar to traditional commercial banks. It includes financial instruments such as hedge funds, money market funds and structured investment vehicles (SIV). Investment banks do much of their businesses under shadow banking system (SBS), while most of the banks are not generally classed as SBS institutions. To give you more straightforward and clearer understanding of shadow banking, I would like to disentangle the information a bit.
Why is shadow banking spotlighted recently? To understand it, we should think back to the wake of global financial crisis. Many share the idea that shadow banking was one of the critical causes of global financial crisis all around the world.
Accordingly, the FSB (Financial Stability Board) is preparing for a policy suggestion to regulate shadow banking, as the issue was raised at G20 Seoul Summit in 2010. SEC (Securities and Exchange Commission) based in US, is currently running regulation over shadow banking in order to stabilize safety of MMFs (Money Management Fund). In the same vein, Korean government has recognized risks of shadow banking, and is designing a variety of countermeasures to regulate shadow banking.
Let us find out why shadow banking is considered risky in some ways. Shadow banking, in plain terms, is a bunch of financial institutions and financial instruments that are subject to less strict regulations compared to other commercial banks and institutions. Typical examples of shadow banking are securities businesses, credit finance corporations, ABS (asset backed securities), bond transaction with repurchase agreements, MMF (money market funds), and the most widely known, hedge funds. The central bank neither monitors nor regulated them, allowing a possible way-out to conceal financial risks which may bring threats to the overall financial market.
Even if you are not so familiar with finance, you would have heard about ‘Subprime Mortgage Crisis’ letting giant holdings, such as Lehman Brothers, collapse. Lehman Brothers, as a shadow banking business, issued imprudent loans to their customers when running out of funds. By recklessly printing out a number of debentures (bonds), they tried to finance their businesses. However, as soon as the US government raised the interest rate for the purpose of stability in mortgage market, Lehman Brother and similar shadow banking businesses all collapsed.
Shadow banking is so closely connected with the central banking system these days, which gives more weight to the issue of shadow banking regulation. To minimize the aftermath of possible risks or crises driven by shadow banking, financial authorities around the world should be more careful and considerate about regulations and supervisions on shadow banking. One of the feasible measures is to request shadow banking institutions to regularly report their businesses conditions, for the purpose of monitoring business soundness. Above all, it would be important to properly educate potential investors to behave in a rational manner.