It is also particularly relevant because shadow banking is said to have played a role in the global financial crisis that started in 2007.
Where’s the shadow?
Shadow banking is a term that covers many types of lending and borrowing that are outside of the traditional banking sector and are sometimes lightly regulated or unregulated and, thus, may operate “in the shadows”. Examples include money market funds and certain investment funds (such as exchange traded funds or ETFs).
The term “shadow bank” was coined by Paul McCulley, economist and former managing director at PIMCO, in a 2007 speech at the annual Jackson Hole financial symposium hosted by the Kansas City Federal Bank. He elaborated on it in this 2009 note.
Globally, shadow banking is very much in the spotlight as figures from international global financial system monitor, the Financial Stability Board, show the sector grew to $71 trillion in 2012 and increased year-on-year at a rate of $5 trillion.
Hiding in the dark
The liquidity offered by some shadow banks sometimes relies on committed lines of credit from traditional banks.
In this situation, when the shadow moves, there is a traditional bank operating behind the scene.
However, there are other shadow banks where liquidity services are offered without such a back-up. For example, a large money manager may lend directly to companies.
European Central Bank vice president Vitor Constancio argued in a 2012 speech some of the positives of shadow banking, including the sector representing “a shift to a more diversified, market-led financial system”.
My shadow is different to your shadow
Although we have a definition of shadow banking above, it is difficult to be exact.
One reason is that shadow banking encompasses such a wide range of instruments it is far from clear exactly what should be included.
Former Bank of England deputy governor Paul Tucker made an attempt when he gave the very broad definition as “the system of credit intermediation that involves entities and activities outside the regular banking system”.
In addition, the rapid evolution of the sector creates challenges.
Finally, despite being a global phenomenon, definitions vary from country-to-country, with the United States, Europe and China all using slightly different criteria.
In the regulators’ spotlight
In her 2013 Back to Basics analysis of shadow banking, International Monetary Fund assistant director Laura Kodres detailed how shadow banks “ran into serious difficulty” at the peak of the 2007 global financial crisis when many investors withdrew or did not reinvest their money.
Following the crisis, regulators across the globe have stepped up their oversight of non-bank institutions recognising that entities from money market funds to private equity firms can have a significant impact on economic stability.
Such a shock happened in January 2014 in China when troubled coal company Zhenfu Energy nearly missed a payment on a shadow banking investment product. As The Economist wrote there was fear that a default could spark panic selling among investors but a last-minute bailout was arranged.
Keeping out of the shadows
Those using standard bank accounts and investment products are unlikely to be affected by the risks associated with shadow banking. Deposits at a bank held up to the amount guaranteed by the government in that country are very safe and unlikely to suffer losses. Similarly those who invest in shares or index funds are likely to face only the usual financial risks associated with investment. However, when investing in alternative assets it may be possible that there is an exposure to shadow banking. Being aware of the amount of risk you are prepared to take is important when investing and managing your money.