Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey : Shadow Banking Is Boon, Bane for Financial System

October 1, 2014

  • Shadow banking differs between countries, shares same underlying drivers
  • Shadow banking contributes substantially to financial risks in United States, much less in Europe
  • Regulators should work together to avoid risks migrating

Shadow banking is both a boon and a bane for countries, and to reap its benefits, policymakers should minimize the risks it poses to the overall financial system.

Shadows on the Tokyo Stock Exchange: the same factors drive the growth of shadow banking across countries (photo: Issei Kato/Reuters/Corbis)

Shadows on the Tokyo Stock Exchange: the same factors drive the growth of shadow banking across countries (photo: Issei Kato/Reuters/Corbis)

GLOBAL FINANCIAL STABILITY REPORT

Shadow banks act similarly to regular banks by taking money from investors and lending it to borrowers, but are not governed by the same rules or supervised. Shadow banks can include financial institutions such as money market mutual funds, hedge funds, finance companies, and broker/dealers, among others.

The IMF’s latest Global Financial Stability Report analyzes the growth in shadow banking in recent years in both advanced and emerging market economies and the risks involved.

According to the report, shadow banking amounts to between 15 and 25 trillion dollars in the United States, between 13.5 and 22.5 trillion in the euro area, and between 2.5 and 6 trillion in Japan—depending on the measure— and around 7 trillion in emerging markets. In emerging markets, its growth is outpacing that of the traditional banking system.

“We found that the same factors often seem to drive the growth of shadow banking across countries,” says Gaston Gelos, chief of the Global Financial Analysis Division at the IMF. “Shadow banking tends to take off when strict banking regulations are in place, which leads to circumvention of regulations. It also grows when real interest rates and yield spreads are low and investors are searching for higher returns, and when there is a large institutional demand for ‘safe assets,’ for example from insurance companies and pension funds.”

Risks, benefits

As the global financial crisis has shown, there are also risks associated with shadow banking due to their reliance on short-term funding, which can lead to forced asset sales and downward price spirals when investors want their money back at short notice.

In the United States, shadow banking accounts for at least a third of total systemic risk, (measured as extreme losses to the financial system that occur with a very low probability), similar to that of banks. In the euro area and the United Kingdom, their contribution to systemic risk is much smaller relative to the risks arising from their banking system. This largely reflects the fact that the latter are still more bank-based financial systems.

In advanced economies, activities traditionally considered less risky, such as non-money market investment funds, have been growing the fastest since 2009; from 35 to 70 percent of GDP in the United States, and from 35 to 65 percent in the euro area.

However, especially in the euro area, these funds are now holding a higher proportion of less-liquid assets, such as commercial loans, compared to five years ago. The IMF observed similar trends in the United States.

This can potentially cause problems if the claims given to investors are very liquid; if many investors want to sell at the same time, funds may not be in a position to meet these redemptions since they would not be able to sell assets quickly. This may result in runs and fire sales, as in the global financial crisis.

Among emerging market economies, the large size (between 35 and 50 percent of GDP), and fast growth (over 20 percent per year), of shadow banking in China stands out and warrants close monitoring. Recently, authorities have taken various steps to combat the excessive growth of shadow banking.

How to manage the boon

Shadow banking can be beneficial. It broadens access to credit, especially in emerging market economies, where traditional banking networks often face capacity or regulatory constraints, such as restrictions on lending or on interest rates.

In advanced markets, various types of funds have been stepping in to provide long-term credit to the private sector as banks have been lending less. Shadow banks also can improve the efficiency of the financial system by deepening market liquidity and risk sharing.

The IMF’s report calls for countries to monitor shadow banking as part of their policies designed to keep the overall financial system safe. The IMF said the degree of shadow banking oversight and regulation should depend on how much it contributes to systemic risk, in line with recommendations by the Financial Stability Board—which brings together national authorities responsible for financial stability.

This macroprudential framework would ensure that shifts in shadow banking to areas where regulation and policy frameworks are weaker would not go undetected. Macroprudential and microprudential supervisors need to work jointly to achieve this.

To assess risks properly, both supervisory authorities and statistical agencies need to provide much more detailed data on shadow banking.

International regulatory cooperation is also crucial. Risks are more likely to increase when regulatory initiatives are implemented by only a few countries, or when they are poorly coordinated. Regulatory tightening in one country, for example, might lead to migration of activities to others with laxer rules. Governments have begun to put in place rules to address the risks through the work of the Financial Stability Board.