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Shadow Banking

  May 20, 2020

Shadow Banking

What is shadow banking?

The shadow banking system is a term for the non-bank financial institutions that provide services similar to traditional commercial banks but outside normal banking regulations.  In India they are largely the NBFCs.

Shadow banking has grown in importance to rival traditional depository banking, and was a primary factor in the subprime mortgage crisis of 2007-2008 and the global recession that followed.

They function as intermediaries between the investors and the borrowers, providing credit and generating liquidity in the system.

Although these entities do not accept traditional demand deposits offered by banks, they do provide services similar to what commercial banks offer. 

In the context of developing economies, shadow banks play a gainful role in credit delivery and financial inclusion as they can facilitate credit availability to certain sectors that might otherwise have difficulty in access to credit. For example, infrastructure financing and micro finance institutions.  They play both a substitute and complementary role for commercial banks.

How are they different from commercial banks?

1. Unlike the banks, which are comprehensively and tightly regulated, the regulation of shadow banks is not that extensive. There is no SLR or CRR requirement

2. While commercial banks, by and large, derive funds through mobilization of public deposits, shadow banks raise funds, by and large, through market-based instruments such as commercial paper and borrowings from banks.

3. The liabilities of the shadow banks are not insured, while commercial banks’ deposits, in general, enjoy Government guarantee to a limited extent.

4. In the times of distress, unlike banks, which have direct access to central bank liquidity, shadow banks do not have such recourse.

What are the risks associated with shadow banking?

The 2008 financial crisis has shown that shadow banking can be a source of systemic risk to the banking system as they borrow from banks and MFs through floating commercial paper. For example, Infrastructure Leasing & Financial Services(IL&FS) that borrowed heavily from banks.

Why is RBI tightening shadow banking rules?

The Reserve Bank is following the trend of global central banks increasing surveillance on shadow banking. Basel III norms require central banks to tighten supervision on shadow banks across the globe through steps such as capital adequacy norms. Its concern stems from the interconnectedness of financial institutions.