The Advantages And The Disadvantages Of "Shadow Banking"

Introduction

Shadow banking gradually formed after the subprime mortgage crisis and it brought a flexible mechanism called disintermediation which can increase financial market efficiency. Shadow banks can be realized as the financial institutions perform similar functions and features with traditional banks but without regulations as traditional banks. They could evade many rules and regulations to perform financial activities, but at the same time, bear more risks without backstopping from the federal bank. Both advantages and disadvantages are existed in the shadow banks. As the scale of such financial institutions grew larger, the problems they faced and the social impacts they made had also caused heated debates among scholars.

Advantages

Commercial banks borrow funds which lending afterward from depositors and investors in capital market. Traditional banks always adhere to the principle of ‘buy-low, sell-high’, they raise the funds from the capital market with a lower interest rate and sell those loans to borrowers with marked-up interest rates. In capital market, shadow banking increases the level of market economic efficiency. Lenders usually need to make a detailed plan before borrowing money, because the cost of borrowing from traditional bank is higher in general cases. Therefore, the borrowers need to make sure they can afford to those cost then make profits. However, if borrowers borrow money from shadow banking which can enable them to borrow without paying that mark-ups, for example, securitization transactions are “accomplished by selling large portfolios of loans to special purpose vehicles, which are legal entities that in turn issue rated securities linked into the loan portfolios”.

Due to the process of securitization which the above diagram shows, there was an explosive growth during the period 2000 and 2006 for Asset-backed securities (ABS). Around 2002, the ABS surpassed the corporate debt and around 2006 the ABS reached its peak. Hence, shadow banking supports Small and Medium Enterprises (SMEs) through the securitization and this will improve the market efficiencies. Apart from disintermediation, positive consequences of shadow banking would be generated by decentralizing lending as well. Decentralization will lead consumers have more investment options which can let them invest into various funds and financial products. Moreover, market stability is less likely to be affected if risk is spread4. For most of small and medium firms are much easier to raise the funds from those decentralized banks compare to traditional banks. For instance, in Mexico, the centralized banks are more likely to give loans across market concentration (banking segment). While, for decentralized banks, the loan can be allocated to those medium firms, but skewed towards competitive market for small and micro firms. Also, bank mergers in the USA tended to increase small business lending due to a sharp fall in the interest rates for competitors to the merging bank. Therefore, the emergence of shadow banking has facilitated the financing of SMEs and promoted the development of SMEs and emerging enterprises.

Disadvantage

Shadow banking brings wrong pricing mechanism to the financial market. Shadow banks are lack of regulatory oversight due to information asymmetry between the lender and borrower. Customers may believe that there will be a low risk but high return which is actually against the risk-return trade off. Because of the mistaken about the risk-return relationship, a large amount of capitals has been attracted from financial market into the shadow banking sector. As a result, shadow bank may disrupt the operation of the financial market. The market for traditional banking may be squeezed.

Funds of traditional banking and shadow banking both had upward tendencies from 1980 in the U. S. Amount of funds of shadow banking firstly over the funds of traditional banking around 2000. The two banking systems equally split the U. S. market in the following 5 years. However, the great financial crisis stopped the growth of shadow banking. The capital flows and transfers caused by the shortage of regulatory oversight may also effect on the development of real economy. Holding abundant capitals, a proportion of shadow banks have invested industries and fields where it is difficult to obtain loans from traditional banks in order to pursue a high return. For example, shadow banks made a low mortgage rate which is even less than current interest rate, to real estate markets with a bubble and massive overbuilding in residential and commercial sectors. Under the injection of capital, US housing prices skyrocketed nationally. However, from July 1990 to February 1992 when the bubble busted, house prices declined nationally by 2. 5%. The steep drop in house price has caused the spiralling default on the thrifts’ residential and commercial real estate loans. Eventually the banking industry was shattered. Meanwhile, a number of real economies encountered a break in the capital chain. Some people worried about banks went bankrupt and they withdrew their deposits. The entire financial market began to encounter the crisis of trust. By the time the government clean-up was complete, the cost of the crisis was $160 billion6. The federal government finally issued a series of laws and regulations for banking assistance to ensure the stability of the financial system.

Conclusion

To customers, borrowers have more investment option choices which can invest into variable financial products through shadow banks. Investors are easily attracted by a high-risk profile. The asymmetry between lender and borrower may potential increase the default risk. To the whole financial market and economy system, the shadow banking could increase capital liquidity and market efficiency. Borrower and lender could be easier finish money transformation than traditional banks without strict regulation. Simultaneously, the risk of shadow banks is increasing accumulated. The funding of shadow banks is unregulated, and the capital flows are invisible and secret. Once the crisis erupts, the bubble will burst rapidly and will be implicated in all walks of industries and the situation would easily become uncontrollable.