In October 2014, the International Monetary Fund (IMF) published its Global Financial Stability Report (“the Report”) entitled “Risk Taking, Liquidity, and Shadow Banking: Curbing Excess while Promoting Growth”. The report asserts that global economic recovery is dependent upon “accommodative” monetary policy in advanced economies by way of shadow banking. At the same time, the Report cautions that prolonged accommodation may also encourage excessive financial risk.
In 2011, the IMF and Financial Stability Board (FSB) conducted a joint study to measure and monitor shadow banking practices globally. The purpose of the Report is to evaluate the scope of shadow banking practices, potential risks and benefits and potential regulatory remediation that would further mitigate market risk.
Chapter 2 of the Report, “Shadow Banking Around the Globe: How Large, and How Risky?”, defines shadow banking as “credit remediation outside of the conventional banking system” and as a result, does not include the safety nets of traditional banks. While shadow banking can be traced to long before the financial crisis, its current use is often described as a means of “regulatory arbitrage”, in response to the more stringent regulations related to capital buffers, liquidity and governance. As a result, banks are less willing to work with smaller borrowers, leveraged loans, etc.
The IMF and FSB study pinpoints the shared characteristics of global shadow banking as follows:
- Shadow banking, in various forms, flourishes where tight banking regulations exist alongside of ample liquidity; and where shadow banking can facilitate the development of the rest of the financial system;
- The US, UK and Euro Area are the top three in shadow banking activities, with a decline in securitization transactions and an expansion of investment funds;
- Shadow banking in emerging countries outstrips banking sector growth;
- Shadow banking in the US carries far greater risk to the financial system when compared to the UK and the Euro Area. In addition, the growth of shadow banking in China stands out;
- The study could not pinpoint whether particular shadow banking activities would lead to increased systemic risk;
- However, the continued expansion of finance outside of the regulatory arena requires an emphasis on systemic risk and increased transparency.
Aside from these common characteristics, the report struggles to identify a common set of traits to further define, categorize and regulate shadow banking activities. This lack of commonality among global financial institutions extends to standard balance sheet risk factors (e.g., run risk, agency problems as the result of too many intermediaries across many financial institutions, opacity, complexity, etc.) based upon country-specific conditions and regulations.
The aforementioned difficulties in finding consistency in global financial markets may be troubling to the IMF and FSB as shadow banking continues to grow, based upon common growth factors in advanced and emerging-market economies. For example, regulatory arbitrage in advanced economies prompted the development of collateralized debt obligations (CDOs) and structured investment vehicles (SIV). In emerging markets, regulatory arbitrage was supported by governments (e.g., Mexico) leading to growth special purpose non-bank financial institutions offering mortgage financing; and subject to less stringent regulations as they did not take deposits. The data used by the IMF do not necessarily conform to our understanding of Shadow Banking, as they lump in a broad amount of assets to what may or may not be any sort of shadowy activity (see Figure 2.6: Size of the Shadow Banking Markets).
Despite further efforts to pinpoint shadow banking balance sheet risk (e.g., liquidity, maturity, credit, leverage, etc.) the report did not provide conclusive evidence due to the inability to quantify risk and measure risk factors using an “apples-to-apples” approach.
The report concludes that regulation of shadow banking activities is needed to the extent that these activities contribute to systemic risk, while also realizing that there is no one-size-fits-all approach. The report provides compelling evidence related to the growth of shadow banking over the last decade; however, its recommendations for oversight require more in-depth analysis prior to the implementation of any regulatory or supervisory requirements.