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What is Shadow Banking

Updated on June 19, 2015

What it is

Shadow Banking is the term used for a group of non-bank financial intermediaries. They provide services like a bank, but do not take deposits. Because of this, they are not subject to a lot of the regulations that surround banks, but are also less secure. Shadow banking is a broad term that includes money market funds, structured investment vehicles, and hedge funds.

Some actual investment and commercial banks conduct business through shadow banking, but are not actual shadow banks.

How They are Different

Shadow banks don`t require a banking license, but as stated before, they never take deposits. Shadow banks get their funds by being sponsored by banks or dealing with parent bank holding companies. They are typically liaisons between large investors and people and corporations who are looking to borrow funds. The bank institution and investor profits from direct fees, or interest collected from the borrower.

Shadow banking systems make up as much as 30% of the total banking system. They are estimated to be worth about $60 trillion. In the global financial crisis, many shadow banks suffered. Most have regained their assets, though shadow banks in the US have declined a lot.

Shadow banks have a place in the global economy, but are different from regular banks in many ways. Because they are less regulated, they can offer loans to borrowers who aren`t able to get financing from a regular bank. Sometimes they can offer credit for a better rate, due to their internal structure. Also because they are less regulated, they don`t have access to central bank funding and generally can`t offer deposit insurance or debt guarantees.

The Risks and Benefits

Shadow banking is considered higher risk that traditional banking. Since they don`t take deposits, but still use short-term deposit-like funding from their investors, they can have times where too much money is withdrawn at once when a group loses confidence in them. Their ability to leverage their risk is less than that of a traditional bank.

The US would like to see shadow banks regulated and passed an act in 2010 that started this process. Their main goal is to reduce risks for consumers. At this point there are still very few regulations, though hedge funds whose assets total more than $150 million are required to register.

The global financial crisis of 2007-2012 was partially blamed on the shadow banking system and economists feel that regulating it would reduce the risk of this happening again.

Because it can be very hard for some people to get the loans they need, shadow banking can be very valuable. Because of their structure, they can take the risk on people the bank won`t approve. This can allow students and lower income people to get the schooling and products they need financing for.

Even if regulations are put into place, shadow banks will still be an important part of the financial system. If regulated, their procedures might change to some degree, but they will still offer many of the same services and be of great value to consumers.

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