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Is Shadow Banking Dangerous for You?

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From hedge funds to mortgage-backed securities, unregulated and risky activities have fallen out of favor since the Lehman Brothers debacle. Aggressive, casino-type behaviors and obscure transactions definitely played an important role in the run up to the financial crisis of 2008. But are all financial activities that operate outside the regular banking system bad? Is anything that is lightly regulated or not regulated at all dangerous for the economy and bad for you?

Five years after the beginning of the financial crisis, we need to ask the question and come up with a good answer. "Shadow banking" is defined as credit intermediation involving entities and activities outside the regular banking system. Hedge funds and leasing companies participate in these activities, but so do trust financing companies, pawn shops and individual money lenders in the developing world. And whether they happen in the shadows or in daylight, shadow banking is an important source of funding for the private sector. The problem is that it is also a source of systemic risk.

The most recent Economic Premise, "Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets?" gives us a very good idea of what it is at stake. Authors Swati Ghosh, Ines Gonzalez del Mazo and İnci Ötker-Robe, talk of the need for policy trade-offs "to ensure that shadow banks provide alternative but safe sources of funding to the private sector without generating additional systemic risks."

While shadow banking in rich economies tends to involve complex and opaque chains of intermediation -- as we all saw with mortgage-backed securities -- they tend to be simpler in emerging-market and developing economies. Nevertheless, as the Economic Premise authors argue, the risk of shadow banking comes both from its growing importance in the overall financial system and its interconnectedness with regulated activities.

The Financial Stability Board, which coordinates at the international level the work of national financial authorities, estimated the size of the global shadow banking system at about US$60 trillion in 2010 representing 25-30 percent of the total financial system, or about half the assets in the regular banking sector -- compared with an estimated US$27 trillion in 2002.

China is a case in point. While subject to significant difficulties of measurement, off-balance sheet and underground lending is estimated to have more than tripled by the end of 2010, from RMB 3 trillion in 2007. Anecdotal information suggests that the share of nonbank loans may have increased from 8.7 percent of total loans in 2002 to as much as 79.7 percent in 2010.

There are growing concerns about the challenges shadow banking could have in the stability of China's financial system. As the bulk of trust financing, for instance, goes to infrastructure projects and high-return sectors, there's the risk that a decline in the economy or in asset prices could lead to an increase in defaults.

As a result, the Chinese authorities have undertaken some measures, like plans for increased monitoring and indirect regulation of shadow banking activities, and efforts in Wenzhou to convert underground loan companies into local banks servicing small and medium enterprises.

It's still early to say exactly how these measures will turn out. But the way China deals with its own shadow banking system will be of relevance for the rest of the world -- especially vis-à-vis better monitoring and supervision, even if indirectly. After all, the rise of shadow banking, here in the U.S. or in an emerging market like China, has been the result of tight controls on the regular banking system.

So to ensure that shadow banks are not dangerous for the economy or for you, we can start by following the recommendations included in Economic Premise. Improved data collection, better cooperation between regulatory agencies of both banking and nonbanking institutions, and expanded capital markets in emerging economies are a good way to begin.

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