Looming Dangers of the Shadow Banking System

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Generally the word “shadow” emits a dark, ambiguous and negative image. Usually in a story, the bad guy would be depicted as a dark character, whereas the good guy would be full of life. The word “shadow banking” applies to this scenario as well. Let’s look closely into shadow banking.

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What is shadow banking? It’s a concept coined in 2007 by Paul McCulley of PIMCO, but its exact meaning is not straightened out yet. The word “shadow” was added because its profits and loans are a mystery due to the complex structure of the investment target; unlike ordinary financial markets that distribute money through bank loans. It can be seen as an untraditional banking system loan in the form of institutions or financial products through market intermediary methods. Although it is identical to the traditional banking system in terms of how it intermediates credit, expiration and liquidity conversion, it can be differentiated by how multiple financial corporations are connected, including banks, during the mediating process. It functions as any other bank, but it is not as stringent. Since it cannot be as flexible as the central bank in providing support or sufficient protection for depositors, there is high possibility of systematic malfunctioning.

Then, how does it function? Shadow banking plays two major rules in the contemporary society. First, riskless assets are created by fluidization. During the process of fluidization, it satisfies investors’ demands by creating riskless assets. Second, it reuses guarantee to activate trade. It uses comparatively scarce guarantees to incur as much financial trade as possible. In countries like America or Europe where the financial system has been stable for a long period, shadow banking is relatively new. During international discussions held in the FSB(Federal Security Bureau) regarding regulations on shadow banking, it was considered excessive when initiated in the status quo. Thus, there should be more discussions on the standards for shadow banking regulations maintaining the balance between stability and development.
Recently, China’s cabinet has distributed rules to regulators aimed at limiting the growth in loans created by untraditional methods for bank lending, according to a copy of the document. In the plan, the State Council calls for stronger oversight of such informal lending by the central bank and other regulators. Likewise, the flexibility of the shadow banking system has served as its main advantage, but now many have become doubtful. The shadow banking system has the possibility of exposing the larger financial markets to excessive systematic risk. While investments are made with some level of risk, the unknown consequences of having such a large shadow baking system may lead some investors to prefer more traditional investment strategies in the future.

By Hojung Min

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