What is Shadow Banking?

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The term 'shadow bank' coined by economist Paul McCulley refers to a system that engages in bank-like activity outside of the banking system. These financial institutions while rendering bank-like services are not supervised and regulated like other banks.

Shadow Banking as explained by the Financial Stability Board (FSB), which coordinates the work of national financial authorities at the global level, is credit intermediation that involves activities as well as entities outside the purview of the banking system. The system symbolizes one of the several flaws of the financial system that results in global crisis.

Reason for rise of Shadow Banking

Shadow Banking is scaling to higher levels globally and as per the Financial Stability Board it increased from $26 trillion to $62 trillion during 2002-2007. Thereafter,hit by the global financial crisis it reached levels of $67 trillion in the year 2011.

The reason for rise in shadow banking is mainly attributed to lack of complete penetration of banking service in an economy. As for instance, in China where small enterprises find it difficult to get finance from the regulated Chinese banking system, shadow banking has emerged to fill the gap.

Risks associated with shadow banking

Shadow banking entities with highly leveraged could face liquidity crunch at some point of time. And, as they are not regulated like other banks, such entities may not be able to raise or borrow funds from the central bank of the economy and hence very soon may face solvency risk. Being an integrated, interdependent and interconnected system, problems in the shadow banking system may pose a systemic risk to the entire financial system. So, regulators in different economies from time to time come up with guidelines to curb and restrict shadow banking.

Shadow Banking in Indian context

In India, the growth of shadow banking is limited and different institutions such as NBFCs that form the part of shadow banking are however regulated by the apex financial institution in India.

Nevertheless, an international body of financial regulators reported, a substantial increase in the exposure of Indian banks to 'shadow banking' entities with total asset base reaching $71 trillion by 2012 end.

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Read more about: banking, shadow banking, china, nbfc
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