June 24, 2020

Shadow Banking – A Necessary Evil?

By Tim Hildebrandt

The case of India

Shortly before the 2018 elections, Indian Prime Minister Modi threatened to give direct orders to the Indian Central Bank. He made this threat in connection with a liquidity crisis in the non-bank lending sector (Mundy 2018). The non-bank lending sector can generally be assigned to the shadow banking sector.

The term shadow banking makes one think of something dark, sinister or simply dubious. This feeling is reinforced by reporting on the shadow banking system, as it was made partly responsible for the global financial crisis in 2008 (Sivramkrishna 2019, 29). It is worthwhile to leave behind your own unpleasant gut feeling in order to deal with the shadow banking system without prejudice. This is worthwhile because the reality of shadow banking is not necessarily as negative as the term itself. For this reason, the shadow banking system in general and for India, in particular, is examined below.

What is shadow banking?

There is no uniform definition for shadow banking. Moreover, the term is used in different ways in different countries. Roughly speaking, this term refers to entities that are outside the banking system but perform bank-like functions (Sivramkrishna 2019, 30). The functions of shadow banks (or NBFI – Non-Banking Financial Institutions) include collective investment vehicles, lending dependent on short term funding, market intermediation dependent on short-term funding, facilitation of credit intermediation, securitization-based credit intermediation (Financial Stability Board 2020, 5). The assets of the global shadow banking system amounted to approximately USD 184 trillion towards the end of 2018 (Financial Stability Board 2020, 6). The assets thus exceed the gross domestic product of the world (World Bank 2020).

On the basis of a market-oriented approach, it can consequently be assumed that shadow banks are somewhat like banks (Sivramkrishna 2019, 31). Shadow banks thus represent an important addition to the banking system, as they can, for example, meet the demand for microfinance products or offer access to financial products to undersupplied segments of the population/economy (Kumar 2017, 96). Apart from widening access to financial services, shadow banks strengthen competition in the financial sector and diversify its structure (Sinha 2013, 2). However, the existence of the shadow banking system also entails various risks.

Risks of shadow banking

At this point, it is worthwhile to refer back to the example from the beginning. Since 2015, non-bank lenders had been responsible for almost one-third of all loans in India. However, this growth was largely based on short-term loans. Due to some defaults, the shadow banks were now threatened with a shortage of liquid funds (Mundy 2018).

As the example shows, shadow banking can contribute to financial instability and systemic risk, as shadow banks do (usually) not have access to central bank funding and are denied access to deposit guarantee schemes. They are therefore very vulnerable to shocks and can accelerate a systemic crisis (Gandhi 2014, 3). This also makes them susceptible to so-called bank runs. Furthermore, the existence of a shadow banking system poses challenges to monetary policy. The structure, size and operations of the shadow banks can distort the input to monetary policy indicators and thus disrupt the functionality of monetary policy. Furthermore, shadow banks usually operate pro-cyclically (i.e. following the economic cycle). This means, for example, that shadow banks expand their business during periods of economic boom and restrict their business activities during periods of recession. This reinforces the economic cycle in both directions (Gandhi 2014, 4).

Shadow banks, therefore, offer various advantages but also harbor some significant risks.

The case of India

In order to concretize the concept of shadow banks, as well as their advantages and disadvantages, India is to serve as a practical example.

The shadow banking sector in India contains mainly NBFCs (NBFCs are roughly speaking NBFIs registered as companies) and collective investment vehicles (or mutual Funds). Special attention should be paid here to NBFCs, as they are fundamentally different from shadow banks in other countries because they are regulated by the central bank (Kumar 2017, 91). NBFCs or non-banking financial companies in India are companies that carry out financial activities (e.g. granting loans, investing in shares, etc.) without being regular banks (Sinha 2013, 7). After India’s economic opening in 1991 (which also included the liberalization of the financial markets), the need for financing increased. This made it possible for the shadow banking system to grow (Sivramkrishna 2019, 37). Today the Indian shadow banking system is relatively small (in absolute numbers). This is mainly due to the (still) conservative laws regarding the financial market (Nandini 2014, 61). In 2011, the assets of the shadow banks in India amounted to 21% of gross domestic product (compared to 86% for regular banks). However, NBFCs have been growing much faster than conventional banks (Nandini 2014, 61).

In India, shadow banks are of particular relevance to the economy, as the (state-owned) banking system has problems with large amounts of bad corporate debt. The liquidity crisis in 2018 was largely due to home loans. These loans with a 10-year term were borne by mutual funds with an overnight redemption. This system was partly supported by the fact that higher-value banknotes were demonetized in India in 2016. This had led to citizens depositing their cash with fixed-income mutual funds (Mundy 2018).

This led to an increase in lending.  The illiquidity of the NBFCs following the collapse of an infrastructure financier could only be averted through the intervention of the Indian Central Bank. By the beginning of 2020, however, the situation had eased considerably. According to the Indian central bank, only 3 to 4 of the 50 NBFCs reviewed still showed signs of stress. (Nag 2020).

The case of India shows that although shadow banks can be dangerous for the economy, they also fulfil important functions for the economy. It is not appropriate to demonize shadow banks, but possible undesirable developments must be kept in mind to prevent crises. 

Sources:

Financial Stability Board (2020): Global Monitoring Report on Non-Bank Financial Intermediation. Available at: https://www.fsb.org/wp-content/uploads/P190120.pdf. Retrieved on: 01.06.2020.

Gandhi, R. (2014): Danger posed by shadow banking system to the global financial system – the Indian case. Address at the ICRIER’s, Mumbai, 21.08.2014.

Kumar, Shri Anand (2017): Non-Banking Finance Companies in India’s Financial Landscape. Reserve Bank of India, Billetin, October 2017, p. 91-104.

Mundy, Simon/ Sender, Henny (2018): How the rise of shadow banking fed India’s ‘clash of egos’. Financial Times.

Nag, Aniban/ Flanders, Stephanie (2020): RBI’s Das Sees Shadow Bank Crisis Abating as Liquidity Improves. Bloomberg. Available at: https://www.bloomberg.com/news/articles/2020-03-03/indian-central-bank-s-das-sees-risk-in-just-four-shadow-banks. Retrieved on: 01.06.2020.

Nandini, N./Jeyanthi, M. (2014): Concept of Shadow Banking in India. Global Journal for Research Analysis, Vol. 3, Issue 11, p. 60-62.

Sinha, Anand (2013): Regulation of shadow banking – issues and challenges. Address at the Indian Merchants’ Chamber, Mumbai, 07.01.2013.

Sivramkrishna, Sashi/ Gune, Soyra/ Kandalam, Kasturi/ Moharir, Advait (2019): Shadow Banking in India: Nature, Trends, Concerns and Policy Interventions. In: Review of Economics & Business Studies. Vol. 12, Issue 2, p. 29-46.

World Bank (2020): GDP (current US$). Available at: https://data.worldbank.org/indicator/NY.GDP.MKTP.CD. Retrieved on: 01.06.2020.

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