Why the Shadow Banking System matters?

The main problem in this system is the regulation part that doesn’t exists in such a system. The system being not regulated means that it is a very risky system that can cause numerous losses. The Shadow Banking System has come to play an increasingly significant role in facilitating credit throughout the global financial system. The lack of government regulatory oversight of the shadow banking system led to excesses precipitating in the global financial crises around 2008-2009, which is the worst economic crisis since the Great Depression of the 1930s. Moreover, this system remains highly leveraged, with a high ratio of debt linked to their liquid assets on hand to pay immediate claims. Yes we wont forget that the higher the leverage the higher the returns but also it carries outsized risk with no rules and regulations.

What are the characteristics of the Shadow Banking System?

One of the main characteristics for the Shadow Banking System is that it tends to be less regulated when it is compared to traditional banks that are highly regulated. Second main character is that the fact which states that this system tend to be less regulated than the traditional banks indicates that regulatory arbitrage drives the demand for shadow banking. In addition, the fact that this system is not regulated heavily shows how risky the system is, however, the higher the risk the higher the return as well.

How does the Shadow Banking System works?

The Shadow Banking System is an institutions network, these institutions work as intermediaries between investors and borrowers. The system provides credit and capital for the following: investors, institutional investors and corporations. The Shadow Banking System’s profits come from the fees and the arbitrage opportunities in interest rates (Arbitrage = riskless profits). One of the classic strategies that are used in this system is borrowing from short-term liquid markets such as commercial paper markets and then investing these funds in longer-term that are less liquid assets such as securitized mortgages.

What is Shadow Banking System?

When an institution acts like a bank, it doesn’t mean that this institution is an actual bank; in fact, we can call this a Shadow Bank. Now specifically a Shadow Banking System is nothing but a network of non-financial institutions which are classified as non-depositary banks such as: investment banks, hedge funds, non-bank financial institutions and money market funds. This system is able to avoid standard banking regulations through the use of credit derivatives, which is considered one of the major problems during the crises around 2007-2008.

Shadow Banking Slideshow

Shadow banking