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  • Writer's pictureNyayshastram

Lessons for the Shadow Banking System in India

Khushboo Arora, Student, School of Law, CHRIST (Deemed to be University), Bengaluru


Financial markets depend not only on credit expansion within formal, regulated banking networks, but also within unregulated, or shadowed, banks. Shadow banks operate outside the control of the monetary authorities, unlike regular banks.

While lending and borrowing decisions are subject to systemic and unquantifiable risks, unregulated banks ' transactions can further escalate these risks by finding new risk types inside informal credit networks. Because these networks also lead to excess risks for lenders when providing additional credit, additional charges are imposed on the borrowers. Thus the trend of these credit networks emerges, especially in developing countries where large sections of borrowers cannot afford the high cost of such loans.

In the developing area, unregulated banks have two versions. The first group offers credit to the population in the informal sector (often financially excluded) that is typically onerous terms. The second type of shadow banks, called Non-Banking Financial Companies (NBFCs), usually deal with the formal market, both in terms of their general clientele and in particular with regular banks as significant providers of funds. These often rely on public deposits, bond-floating on the market and regular bank borrowing. Much of these funds go into high-risk activities. The two versions, which tend to various sectors of the economy, play tasks and entail very different risks.

Shadow banking plays a gainful role in credit distribution and financial inclusion in developing economies such as India. They play both a replacement and a complementary role for commercial banks, as they can meet borrowers ' needs outside of the regulated banking system's overview. Shadow banking, however, is becoming very dangerous because it exists outside of the formal banking system and financial intermediation practices are conducted with less transparency and supervision than traditional banking. It allows the financial system to grow up to a certain level; but beyond that, it may prove risky.

The term ' shadow banking ' is widely attributed to Paul McCulley, economist and investment manager, who used it to refer to ‘the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures’.[1]

According to a report by the Financial Stability Board[2], the prevalence of the following conditions spur the growth of institutions engaging in shadow banking activities:

· Stringent banking rules coupled with meagre rates of interest and yield rates.

· Existence of a large number of investors in search of higher returns.

· Massive demand for assets from institutions.

The growth of the shadow banking system

Traditional banks make these short-term deposits, investing the money in long-term assets like loans, rentals, and mortgages. Pozsar defines the functioning of the shadow banking system as structured around wholesale financing by depositing like instruments and long-term asset securitisation.[3]

There are two reasons on the scale of the bid why financial institutions are involved in shadow banking. The first explanation for this is the banks' side quest for yield. Over the past 30 years, the banks substituted deposits for fee-based wholesale funding as competition in the banking industry increased. Pozsar argues that this mechanism has transformed banks from low-return on-equity (RoE) utilities that originate and hold loans and finance them before deposit maturity to high ROE organisations that originate loans for warehousing and then securitising and distributing them or holding securitised loans through off-balance-sheet vehicles.[4]

A second reason involves attempting to escape bank regulation and capital requirements in particular. Using structured finance instruments and financial holding companies, banks were able to expand their leverage, which boosted their expected returns and also their overall risk exposure. However, this tendency was compounded by the weak monitoring incentives offered in the latest originate-to-distribute model during the origination process and the skewed incentives created by the framework for rating agencies, which had to verify the standard of the securities used as collateral.

Cross Country Regulation

i. Post-Crisis Growth Tailwinds: Global post-crisis shadow banking growth has been driven by increased banking regulation, low-interest rates, a generally beneficial economic context, growing financial technology, and increasingly supporting government policies to promote economic development and availability of credit.

ii. The U.S. Has Largest, but Declining Share: According to the FSB, the US is home to the world's largest shadow banking market, totalling $14.9 trillion as of 2017. That being said, U.S. shadow banking assets have only risen at a compound annual growth rate (CAGR) of 0.8 per cent since 2010, compared to an 8.3 per cent global CAGR. This can be explained by the relative maturity of the U.S. shadow banking industry versus global peers, the decline in some pre-crisis shadow banking operations, and/or some previous domestic activities going offshore.

iii. Market Development and Tax Status Drive Size: There is usually a high correlation between the size of the shadow banking assets of a given country and the overall development of the financial markets. Attributes such as deep/liquid capital markets, regularly implemented financial regulations, and well-defined creditor protections can be more supportive of non-bank financial intermediation development. More favourable tax regimes also tend to attract more shadow banking assets including the Cayman Islands (10.4% of global shadow banking assets as at YE17), Luxembourg (6.9%) and Ireland (5.4%).

iv. Generally Low, But Rapidly Growing Emerging Markets: Shadow banking growth rates in emerging market economies were higher than established peers, driven primarily by country-specific market development and the fact that those countries began from smaller absolute asset bases. China is the only country among emerging market economies that is big, both in terms of the notional size and the pace at which those assets are rising.

Challenges posed by shadow banks in the Indian context

RBI has several responsibilities such as addressing the threats to financial stability posed by shadow banks, addressing the interests of depositors and consumers, addressing regulatory arbitration and also helping the financial sector to expand healthily and efficiently.[5]

RBI faces various challenges related to the law such as dealing with different organisations that are:

a. registered as finance companies, but do not come under the regulatory supervision of the RBI;

b. unincorporated bodies who undertake financial activities and remain unregulated;

c. incorporated companies and unincorporated entities illegally accepting deposits;

d. entities are camouflaging deposits in some other names and thus illegally accepting deposits.

The truth is that the legislation is ill-equipped to deal with such revolutionary initiatives that are manipulating the existing legal framework.

Shadow banking organisations, especially unincorporated ones, can spring up anywhere and operate with impunity. Therefore, a mechanism for successful market analysis can be put in place to capture such action against such companies as soon as possible in order to secure consumer interests.

Conclusion and Suggestions

Although 'shadow banking' has only recently come to the forefront of regulatory and policy discourse in its current form, bank-like entities outside the regulated banking system are not fresh. Instead, regulations are a natural and potentially beneficial result. The regulatory body has too readily refused to regulate prudential banks for 'shadow banks.' At the same time, there is a move to restrict commercial banks ' exposure from organisations and activities that do not participate in' traditional' banking activities.

Underlying these attempts is an obsolete, dichotomous view of the financial world; organisations and actions either operate as banks and ought to be subject to banking laws (and in the United States, regulated by a banking regulator), or are non-bank institutions and should be distinguished from traditional banks. Such a perception is obsolete within an increasingly complex financial system. The planet does not consist solely of banks and non-banks. The shadow banking system is not universal, but companies that have bank-like features now exist. So we need to look beyond legal labelling and prioritise risk-generating behaviours.

By complex, pragmatic policies that try to preserve the advantages of shadow banking while targeting specific activities, however, we may alter the distribution and risk character of banks and non-banks. When done carefully, we can create a financial system that is both flexible and robust, with thorough use of the various tools available to both government and industry.

Potential Regulatory Strategies

In the case of shadow banking system-specific activities, the regulatory objective should be to try to prevent systemic crisis and financial crisis pro-cyclicality without increasing costs in a reasonable time.

Therefore we can use four basic types of regulation if we want to avoid systemic crisis:

a. Regulation which restricts the deposit liquidity as instruments: Policy options include refund fees or windows, suspension of convertibility, an overhaul of bankruptcy laws to limit repos to “automatic stay” rules[6].

b. Regulation restricting the use of deposit as tools for funding long-term investments: Potential regulations include capital requirements, limits on the use of company assets, and liquidity conditions, such as liability maturities laddering.

c. Regulation for tackling structural crisis once it happens: But proper regulation will unlikely to avoid all systemic crises. As part of the regulatory efforts should be directed at developing the best policies for coping with the crisis once it arises, helping to recover the system's solvency rapidly and without externalities being placed on third parties.

Hence, proper resolution mechanisms are essential to design. Such strategies can both minimise structural crisis costs as they arise, and reduce the likelihood of their occurrence by adjusting the institutions ' incentives to over-leverage. Such resolution strategies may include the use of contingent capital, the use of convertible debt to remunerate financial institution managers and the creation for financial institutions of special bankruptcy procedures that turn debt into equity using options.

Thus, Shadow banking is an alternative to the banking system. If appropriate regulatory measures are taken, the future of financial growth will easily depend on shadow banking at a time when there is a cash shortage in the banking sector or other financial sectors.


[1] Paul McCulley, Teton Reflections: PIMCO Global Central Bank Focus, PIMCO (September 2007) [2] Global Shadow Banking Monitoring Report 2011, Financial Stability Board (2011) [3] Stijn Claessens, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh, Shadow Banking: Economics and Policy, IMF Staff Discussion Note (December 4, 2012) SDN/12/12. [4] Stijn Claessens, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh, Shadow Banking: Economics and Policy, IMF Staff Discussion Note (December 4, 2012) SDN/12/12. [5] RBI Annual Report, 2018, [6] The “safe harbour” status of repos and CDS in bankruptcy increases the “money-likeness” of these instruments. Currently they have the highest priority, higher than secured debt, because they are excluded from automatic stay in bankruptcy that applies to all other claims. CDS are executed even in bankruptcy and collateral collection in repos also continues during bankruptcy. This generates an implicit subsidy for these modes of financing.

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