## What Is Shadow Banking?

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### I. Introduction
- Paper identifiers and authors:
  - WP/14/25
  - Prepared by Stijn Claessens and Lev Ratnovski
  - February 2014
  - JEL Classification Numbers: G21, G23, G28
- Core problem:
  - Existing definitions (e.g., FSB (2012): “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”) have weaknesses:
    - May include entities not commonly thought of as shadow banking (leasing and finance companies, credit-oriented hedge funds, corporate tax vehicles).
    - Describes shadow banking as operating primarily outside banks, yet many shadow banking activities operate within banks (liquidity puts to securitization SIVs, collateral operations of dealer banks, repos).
- Functional approach:
  - Treats shadow banking as a set of intermediation services (see Figure 1: securitization, collateral services, bank wholesale funding arrangements, deposit-taking/lending by non-banks).
  - Strengths: focuses on demand for services and how services are provided; recognizes genuine demand beyond regulatory arbitrage.
  - Limitations: does not identify essential characteristics; struggles to predict future forms or distinguish superficially similar activities with different systemic risk.

### II. A New Way to Describe Shadow Banking
- Proposed definition:
  - “All financial activities, except traditional banking, which rely on a private or public backstop to operate.”
  - Intention: capture current and likely future shadow banking activities (examples noted: agency REITs, leveraged finance, reinsurance in the U.S.).
- Rationale: Why shadow banking activities rely on a backstop
  - Shadow banking, like traditional banking, involves risk transformation (credit, liquidity, maturity risks).
  - Traditional banking transforms risks on a single balance sheet using law of large numbers, monitoring, capital cushions to convert risky loans into safe assets (deposits).
  - Shadow banking transforms risks using capital-market-like mechanisms to distribute undesirable risks across the financial system (examples: tranching, liquidity puts, collateral reuse in repo markets).
  - Residual or “tail” risks remain (systemic liquidity risk in securitization; bankruptcy risk in repos and securities lending; systematic component of credit risk in non-bank lending).
  - Key constraints that necessitate an external backstop:
    - Margins in shadow banking are low (focused on hard-information risks that are contestable), thus internal capital accumulation for backstops is insufficient.
    - Shadow banking often operates at large scale (to offset start-up and infrastructure costs) and faces systemic tail risks that can realize en masse.
  - Two external backstop sources:
    - Private: franchise value of existing financial institutions (explains shadow banking operations within or transfers to large banks).
    - Public: explicit or implicit government guarantees (examples cited in text: Federal Reserve securities lending facility (TSLF); implicit too-big-to-fail guarantees for tri-party repo clearing banks and dealer banks; bankruptcy stay exemptions for repos; reputational/implicit guarantees on bank-affiliated products such as “wealth management products” in China; guarantees on liabilities of non-bank finance companies as noted for India).
- Reliance on backstops as a litmus test
  - Activities that do not require external risk absorption capacity (custodians, some market-making services, hedge funds with high margins and investors willing to bear risks) are not shadow banking.
  - Systemically-important shadow banking is characterized by: risk transformation + low margins + high scale + residual “tail” risks and thus need for a backstop.

### III. Policy Implications
- Where to look for new shadow banking risks:
  - Financial activities that need franchise value or government guarantees to operate.
  - Non-traditional activities of banks or insurance companies are “prime suspects.”
  - Example candidates: liquidity services by sponsor banks to exchange traded funds (ETFs); large-scale commercial bank backstops for leveraged financing and buyouts.
- Why shadow banking poses regulatory challenges:
  - Backstops reduce market discipline, enabling accumulation of systemic risks at large scale.
  - In the absence of market discipline, regulation and supervision must act to prevent risk accumulation, which is a large task.
- Regulatory reach and tools:
  - Shadow banking is almost always within regulatory reach, directly or indirectly.
  - Regulators can affect the ability of regulated entities to use their franchise value to support shadow activities (example: post-crisis limits on banks offering liquidity support to SIVs).
  - Regulators can manage implicit/explicit government guarantees (examples: Dodd-Frank Act limits on extending safety net to non-bank activities; efforts to reduce too-big-to-fail).
  - Policy approach: reduce undesirable shadow banking by removing or curtailing its backstop.
- On migration of risks from regulated sector to shadow banking:
  - Large-scale migration is constrained: shadow banking cannot migrate at scale to parts of the financial system without access to franchise values or government guarantees.
  - This narrows where regulators need to look and suggests a starting point for measuring the shadow banking system: activities within banks.

- Additional observations (from paper):
  - Functional diversity across jurisdictions: activities labeled “shadow banking” differ by country (e.g., lending by insurance companies in Europe; “wealth management products” in China; bank-affiliated finance companies in India), raising the importance of the backstop test for cross-country analysis.

*Source: IMF Working Paper WP/14/25, “What Is Shadow Banking?” by Stijn Claessens and Lev Ratnovski (February 2014).*

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