The Pros And Cons Of Shadow Banking

According to McCulley (2009), financing has got creative through the rise of securitization vehicles which has got momentum just before the financial crisis. Now the term represents a broader range of entities and activities. Moreover, ‘market-based financing’ instead of ‘shadow banking’ is preferred by some authorities and market participants. The term ‘shadow banking’ is sometimes deemed as too pejorative to characterize such an important and extensive part of the financial system despite the risks and lack of transparency involved in its activities (FSB, 2013).

Traditionally, credit intermediation between savers and borrowers is executed in a single institution, a bank, which collects deposits and provides loans. First, such activity involves

First, loans, leases and mortgages are transformed to tradable instruments through securitization. Second, their funding is conducted in capital markets with commercial papers and repos. In this case, savers direct their money to money market funds instead of depositing at traditional banks. The whole process is performed in several steps through a chain of non-bank financial intermediaries in contrast to a single bank in traditional credit intermediation. Moreover, the process is performed in a strict and sequential order and each step is conducted by a specific entity (a shadow bank). Effectively, the traditional deposit-funded, hold-to-maturity lending is transformed into complex, originate-to-distribute lending process. The credit intermediation in the shadow banking system includes the

The liquidity in the shadow banking system is ensured by contingent lines of credit and tail-risk insurance in the form of wraps, guarantees or credit default swaps (CDS) provided by the private sector – commercial banks and insurance companies. Such liquidity enhancement forms allow shadow banks to issue highly-rated short-term liabilities and expand lending. However, stability of the shadow banking system and stable credit intermediation to a great extent rely on the solvency of private liquidity providers.

According to Gorton & Metrick (2010) two methods can be successful for regulating the shadow banks, namely, strict guidelines on collateral and government guaranteed insurance. Both of these measures are inherent to the traditional banking and played a major role in rescuing the financial system. Insurance for MMFs and stricter collateral requirements for securitization and repos should facilitate the sustainable development of the shadow banking. Although regulation and supervision is essential for the functioning and efficiency of shadow banking system, it will not the extensively covered in the