Financial and Monetary Affairs

Exposing the mystery of shadow banking

Shedding a light on the significance of the shadow banking sector in the EU.

The Global Financial Crisis (GFC) exposed a number of crucial fault lines in the global financial and banking systems, of which shadow banking was at the very centre. The period following the crisis saw significant reform to the supervisory structures of these systems in Europe, yet much is still unknown about the shadow banking sector.

The cross-sector and cross-border shortcomings exposed by the GFC, alongside the significant growth in the shadow banking sector over the past two decades, have posed a number of problems for regulators in Europe. As of 2018, shadow banking assets in the euro area accounted for more than 40 percent of financial sector assets (almost 34.5 trillion euros). This impressive growth emphasises the strength of the sector and the consequential benefits it can have for the wider economy. Yet, with the shadow banking sector accounting for a significant portion of the financial system, alongside its lack of regulation, there is a crucial need for a greater understanding of the risks it poses. 

So, what is shadow banking?

The mysterious title ‘shadow banking’ manages to infer a level of negativity and suspect legality, leading to presumptions that the sector is both ‘shadowy’ and criminal. This, however, is far from the truth. Although shadow banking does fall outside of traditional banking regulation, it is well within legal bounds. It simply refers to a series of bank-like behaviours (mainly lending) performed by non-bank financial intermediaries, which largely fall outside the environment of traditional banking regulation. The Financial Stability Board broadly defines it as “a system of credit intermediation that involved entities and activities outside the regular banking system”. 

The system itself is not inherently bad, in fact, it can have a positive impact on the economy, acting as an additional source of lending and in turn reducing the dependency on traditional banks as sources of credit. Aside from the term itself, the perception of the role of shadow banking as a significant contributor to the housing market collapse and GFC in 2008, has supported its negative portrayal. During the crisis, many companies became severely overextended. In part, this was because shadow banking actors are not constrained by the same regulations as regular banks. Instead, they were able to, and continue to, operate with higher levels of liquidity and credit risks.

An uphill battle for regulators 

The regulatory issues and systemic risks associated with shadow banking were first recognised globally by the G20 leaders at the November 2010 Seoul Summit. Following the establishment of new capital standards for banks in Basel III and the comprehensive reform of the financial sector, new concerns were then raised about the potential contagion channels between shadow banking entities and the wider banking system, as well as the potential for regulatory arbitrage. Despite this focus on interconnectedness, EU data is still lacking. Overcoming this weakness should be a central focus of regulatory efforts, in order to understand the true size and scope of the sector.

Existing outside the focus of regulatory authorities, activities in the ‘opaque’ shadow banking system have been frequently excluded from standard statistical frameworks. Further, the constant evolution of market conditions, and the changing operations that follow, compound the difficulty of supervisory and monitoring efforts. In 2013 the European Commission highlighted three main issues for monitoring the sector: its size, close links to the regulated financial sector and the systemic risk that it poses. 

Shadow banking exists in a transnational field of governance where regulatory and governmental authorities are split, both within the nation state, and beyond. Even so, attempts at mitigating risk have relied excessively on private risk management to respond correctly to data. Traditional discourse around shadow banking explains the failure of shadow banking as a market failure caused by market imperfections, neglecting the obvious failures of private risk management and instead focussing on information asymmetries. It is clear that a model of market-based governance, which relies heavily on transparency and private risk management, has prevailed in the years following the GFC. Yet, the effectiveness of this model warrants closer attention.

Current Framework

In 2012 the European Market Infrastructure Regulation (EMIR Regulation 648/2012) was introduced, aimed at enhancing transparency and stability through the reporting of all derivatives to trade repositories. Although a significant step, EU level responses have remained limited. Failures on the global stage, such as the failure of setting counter cyclical haircuts, seem to have weakened the position of actors like the European Central Bank in achieving similar legislative projects. The interconnectedness and constant evolution of the sector remains a central challenge for regulators who, lacking a common framework, continue to rely on private agents to assess risks.

In the aftermath of the initial COVID economic shock in March 2020, the Financial Stability Board released a report that called on the international regulatory community to enhance the resilience of the shadow banking sector while still preserving its inherent benefits. Additionally, the European Banking Authority has set guidelines to limit exposures to shadow banking entities, in doing so mitigating risks exacerbated by outside shocks caused by the pandemic. However, the European shadow banking system is so intertwined with international entities that eliminating risks in any significant way is unlikely without a common regulatory framework.

A less shadowy future?

Despite major criticisms of established regulatory frameworks, many of their failures can be explained by a significant gap in knowledge of the size and scope of the sector. The most promising designs fall victim to the complexities of the cross-border and cross-sector system. Before successful regulations can be implemented, the sector needs to be mapped, developing an understanding of the systemic risk that it poses. As we overcome these gaps, regulatory efforts would benefit from embracing the innovative nature of the sector, regulating by function rather than entity. An intrinsic feature of the sector is regulatory arbitrage, and as specific entities become regulated the cycle of innovation continues. As a greater understanding of the sector is developed, policymakers and regulators alike will be better equipped to address issues of systemic risk.

Niamh has obtained a degree in international relations from Monash University in Australia and is currently pursuing her double masters degree in European Governance at both Utrecht University and Konstanz Universität.

Featured image: Shutterstock

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