Shadow banking

Updated August 2018

Shadow banking refers mainly to methods by which credit is created outside of the traditional banking system and beyond the oversight of regulators, often leading to the build-up of dangerous vulnerabilities.

For example, in the run-up to the 2008 financial crisis, the US financial system became heavily dependent on various investment vehicles that were used to funnel funds into the mortgage market. When trust in these entities collapsed, the entire financial system froze and risked becoming insolvent.

Today, the biggest concerns over the shadow banking sector tend to focus on China. As with the US, shadow banking has grown mainly as a way to skirt regulation and meet demand from both borrowers and investors. According to researchers at the Bank for International Settlements, the dominant players in China’s shadow banking system are the commercial banks themselves. Bloomberg, meanwhile, notes that the sector “has ballooned into a $10trn ecosystem which connects thousands of financial institutions with companies, local governments and hundreds of millions of households”.

One of the main facets of the shadow-banking sector is the issuance by banks and brokerages of “asset management products”. These are effectively high-interest accounts that are sold to companies and households. The banks then lend the money to borrowers of varying quality.

There is an assumption on the part of investors in these products that the financial institutions who issued them will stand behind them if they go wrong (similar to the assumption made about “special purpose vehicles” used to fund mortgage loans during the US sub-prime boom). The risk is that, as with sub-prime, something goes wrong, triggering a run on the financial system and a credit crisis in China that could hit growth hard.