advantages and drawbacks of shadow banking activities.
Financial Stability Board (FSB, 2012) defines shadow banking as
a system of credit intermediation (Credit
intermediation is a lending activity where the saver does not lend directly to
the borrower) that involves entities and activities
outside the regular banking system in other words
shadow banking system refers to unregulated activities by regulated
According to European Commission
shadow banking activities consist in:
i. Maturity transformation: refers
to using short-term liabilities to fund long-term assets.
ii. liquidity transformation: refers
the fact that a bank’s assets are less liquid than its liabilities. Assets are turned into
cash then they use illiquid assets to create a more liquid one (e.g. mortgage
is an illiquid asset that can be used to create an equity which is easily sold
and hence more liquid this process is called securitization.
individual loan carries risk specific to a transaction, a bank diffuses its
overall risk exposure by lending to a large number of borrowers.
iv. using direct or indirect financial
to capital lent/borrowed in order to multiply gains (or losses).
There are significant benefits that
shadow banking offers to the financial system by reducing cost of credit and
increasing liquidity of the system through:
1.Securization:is a process of pooling various debt contracts in
order to repack them according to clients’ needs. Here securitization
transforms illiquid underlying assets (e.g. loans) into liquid securities and
thereby increases the liquidity of the financial system.
Market Funds: Money market funds (MMFs) are “investment funds that have the
objective to provide investor with preservation of capital and daily liquidity,
and that seek to achieve that objective by investing in a diversified portfolio
of high-quality, low duration fixed-income instruments.
3.Repurchase Agreements: the borrower borrows money from the lender
for the price difference between the repurchase and initial price and uses
their assets as collateral. highly liquid and low-risk characteristics of
securities led to their acceptance as collateral in repurchase agreements.
4.Decentralization: the shadow banking
system is decentralized, enables specialization and hence further efficiency
gains, it may prevent existence of too-big-to-fail institutions and it supports
competitive environment which has a further beneficial effect on the price of
If shadow banking is not properly
structured, it can represent a source of systemic risk that can easily infect
both the rest of the financial system and the real economy. Firstly, the decentralized
character of shadow banking leads to long and complex financial intermediation
chains. The process of securitization can be in theory repeated without ending
and thereby creates specialized but increasingly opaque securities.
Consequently, pricing of the products becomes very complex as the price should
reflect both the quality of the underlying loans and the risk structure at
every single level.
Secondly, acceptance of securities as
collateral for repurchase agreement builds up leverage. Although leverage is fundamentally related to credit intermediation and is
not harmful itself, it can turn a non-systemic risk into a systemic one.
Moreover, build-up of leverage increases the procyclical nature of shadow
banking and amplifies consequences of financial crises.
Thirdly, the reliance of shadow
banking on short-term liabilities acquired through repurchase agreements to
fund illiquid long-term assets (loans) is inherently fragile
since it is susceptible to modern
bank-runs. shadow banking institutions do not accept deposits, which is the
reason why they are not currently regulated. Moreover, Shadow
banks buy long term assets and finance them by selling short term securities.
However, if investors become wary about a bank’s health, these long-term assets
have to be liquidates with immediate effect. This creates a situation of
Fourthly: Shadow banks are not backed by the central
bank. As a result, they do not have any kind of backup that would save them
from trouble if the depositors suddenly wanted to withdraw their cash. It is
true that commercial banks indirectly back these shadow banking institutions.
However, it is difficult for them to divert cash towards their shadowy arm especially
if a crisis is in progress. This creates a situation where in shadow banks not
only face huge risks themselves but also pose systemic risk. This is because
their business creates the same amount of risk as that of banks. However, they
do not have the preventive regulations or the safety nets that banks have
access to in case things start going wrong. (No access to cash)
big to fail” theory asserts that certain corporations,
particularly financial institutions, are so large and so interconnected that
their failure would be catastrophic to the greater economic system, and that
they therefore must be supported by government when they face potential
failure. ………. Systemic risk and moral hazard
are a principal immediate cause of the existence of too-big-to-fail
growth in bank size increases the moral-hazard risk of becoming too-big-to
the root cause of “too
big to fail” is the fact that in our financial system as it exists today, the
failure of large complex financial firms generates large, undesirable
externalities. These include disruption of the stability of the financial
system and its ability to provide credit and other essential financial services
to households and businesses. When this happens, not only is the financial
sector disrupted, but its troubles cascade over into the real economy. (Barth,
The failure of a large bank as HSBC can be a pervasive
or extensive failure of several financial institutions, first, HSBC have direct
implication on the economy, in terms of high labor force redundancy of a large
bank, and interruption in provision of operations decisively important for
smooth market functioning.
Just to name few aspects of bank operations, the undesirable outcome in this situation would be the interruption
of lending, payment processing, short-term funding, and cash management. Second,
multiple failures have indirect economic effects as well. They cause entire financial market
instability, which spills over and depress real economic activity. Because the
financial institutions are perceived to have very important role in the
real economy, their failure is perceived to represent a disaster.
banks as HSBC are organized by a form system of responsibilities along product
and regional lines. The product heads of the large divisions into which banks
are organized. As in industrial companies, each division has its own management
focusing exclusively on its own divisional business. However, given the size of
HSBC divisions and his reach into many countries and continents, they can no
longer be run by just one divisional executive vice-president, as in the
past. Today, divisions require an extensive management team with their own
support services, such as personnel and legal departments that in former times
were centralized. Below the contemporary divisional managements there are the
large hierarchies necessary for the management of worldwide operations.
of large other banks and/or hiring large teams of product specialists, salesmen
and traders are often necessary for business reasons. Boards and top
managements must be mindful of the risk that a uniform company culture may be
impaired by the invasion of too many outsiders. A great problem lies in the
collaboration of the many back offices of a bank with a large international
network. Many banks have only belatedly realized that they not only require
specialists for their front offices, but equally competent people in their back
offices that must loyally cooperate with their colleagues across their global