What’s the deal with… shadow banking?

Financial services firms, including banks, are an important part of a City law firm’s client base. Therefore, it is important to get to grips with the technical language often bandied about.

One such term is ’shadow banking’.

What does it mean?

The term itself has evolved over time. It was initially coined to describe legal structures used by Western banks before the financial crisis to keep risky, opaque and complicated securitised loans, including mortgages, off their balance sheets.

This was done chiefly through structured investment vehicles (SIVs). By pretending that they had nothing to do with these (notionally) independent structures, banks could portray themselves as financially healthier than they actually were. However, following the recent financial crisis banks must now incorporate SIVs onto their balance sheets.

Today, the term shadow banking is used much more broadly than simply referring to SIVs. It is defined by the FSB as lending by anything other than a bank.

Furthermore, bankers talk about ‘shadow banking’ in a much more sweeping way to refer to any financial institutions that banks see as encroaching on their business. From this perspective, the term denotes any bank-like activity undertaken by firms not regulated as a bank – for example, the mobile payment system offered by Vodafone, or investment products sold by BlackRock.

Why is it important?

The scale of shadow banking is astonishing: $75 trillion worldwide. It is growing at phenomenal rates in China and India and booming in Western banking capitals as well. According to the Financial Stability Board (FSB), an international watchdog set up to guard against financial crises, shadow banking accounts for a quarter of the global financial system.

Although the term had largely negative connotations during the financial crises, its growth has in fact been encouraged by steps taken by regulators in the aftermath of the credit crunch and may be considered as a positive development.

Shadow banking
Although the term may evoke an image of institutions that are up to no good, shadow banking plays an important role in providing alternative finance options.

Why is it on the increase?

Shadow banking, as currently understood, is proliferating because orthodox banks are on the back foot, battered by losses incurred during the financial crisis and beset by heavier regulation, higher capital requirements, endless legal troubles and swingeing fines.

The banks are retrenching, cutting lending and shutting whole divisions. City banks have slashed their loans to businesses by almost 30 per cent since 2007. Shadow banking has stepped in to fill in these gaps.

In particular, banks have an especially strong incentive to curb long term loans to business. The reasons for this are two-fold, namely that regulators requires banks:

  • to hold more capital against long term loans – this is because long term loans are more risky and a greater amount of capital is required to act as a cushion in the event that the borrower defaults; and
  • to fund such loans in part with long-term borrowing, which is more expensive than overnight or short term borrowing.

As a result, banks are much more reluctant to lend to businesses on a long term basis unless the profit margin that they can obtain makes it commercially attractive for them to do so.

Although the term may evoke an image of institutions that are up to no good, shadow banking plays an important role in providing alternative finance options.

Bernard Mustafa is president of BPP’s Commercial Awareness Society

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