Shadow Bank is one kind of financial institution which provide credit and liquidity to various investor and brokers but like the traditional bank or the regular bank, it does not have its access with the central bank and have very less regulation than that of the traditional bank. A Shadow banking system is a group of various financial institutions that works globally which are involved in various unregulated activities by the regulated institution.
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How does Shadow Banking work?
Shadow Banking does not take deposits from people or investors like the traditional bank. They provide various short term funding like commercial paper, unlisted derivatives, and other unlisted instruments.
Basically, shadow banking lends money and various instrument from the traditional bank and lends it to various investors. Here there is no initial security is taken from the investors. This is basically done to raise the stock prices and to get the initial investment for various projects. The traditional bank also provides the fund to this Non-Banking Financial Companies (NBFC) or shadow banks to get the advantage to high return from an investment.
Thus shadow banks borrow money from the regular banks and then provide it to investors for a particular period of time and if the investors are not able to provide the money-back then the traditional bank will run out of money and that will result in financial crises in the market.
The most common example of shadow banking is considered to be the recession of 2008. In 2008, one of the classic strategies employed by shadow banking institutions was borrowing short term commercial paper from the markets and use that short term funds to invest in a longer-term fund to securitized the mortgages. When the housing market collapse in 2008, resulting in a large distraction in the market. Shadow banking institutions could no longer borrow sufficient funds to operate. The short-term loan was almost dried up overnight, for the lenders feared what was a risk of credit was, simultaneously the Shadow Institutions were unable to get money from their collapse in mortgage-backed securities investment and the same results were seen in traditional banks.
Pros of Shadow Banking:
- The shadow banking system offers credit and also provides liquidity and funding in addition to that provided by the traditional banking system.
- It can often provide credit more cost-efficiently than traditional banks.
- This system is very important for the economy because it provides funding to traditional banks and without this funding, traditional banks would not lend money, which would then slow growth in the wider economy.
- It also reduces the dependency on traditional banks as a source of credit this is a positive benefit for the economy.
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Risks associated with Shadow Banking:
As shadow banks do not take deposits from investors as they are less regulation than traditional banks. They can, therefore, increase the rewards they get from investments by leveraging up much more than traditional banking and this can lead to high risks in the financial system. Shadow banks can also cause a buildup of systemic risk indirectly because they are interrelated with the traditional banking system through credit intermediation chains, thus the problems in this unregulated system can easily spread to the traditional banking system. Shadow bank collateralized funding is also considered a risk because it can lead to high levels of financial leverage in the system.
The shadow banking systems play a critical role in the various financial risks in the market. Apart from traditional banks shadow banks is very fragile because it works with very less regulation. Along with these situations, the shadow banking system has a competitive advantage over traditional banks to grow more rapidly than the traditional banks
Author: Charmi Mehta
About the Author:
Charmi Mehta is currently pursuing an MBA with the specialization of Finance from the Department of Business Administration, Bhavnagar. She is fascinated by the financial market and has a strong interest in data analysis.