Review on Shadow Banking

Investment Management             1385163                          CAODANQING

Shadow and substance

 “Shadow banks” is taking over the business which is originally part of the bank’s service area.

The Royal Bank of Scotland seek expansion at the breakeven speed but went out of money. So it tightened the credit policy and charged Hall& Wood house a high interest rate. Due to this, Hall& Wood house decided to loan facility form more reliable long-term creditors and thus turned into a shadow bank—a financial firm that is not regulated as a bank but performs many of the same functions. M&G offered them ￡20m over 10 years.

Shadow banking got bad reputation during financial crisis period in the form of off-balance-sheet vehicles which are notionally separate from banks but actually dependent on them. What’s worse is that they relies on short-term funding from money markets where businesses, institutions and individuals invest spare cash for short periods. The loss in the money market led to troubles of banks and other financial institutions relying on them for short-term borrowing that they couldn’t repay the creditors, so that the governments had to bail them out. Since then, putting suspect assets in off-balance-sheet vehicles became very hard owing to the restricted manoeuvre and new accounting rules. Instead, lending should be recorded as lending and banks are now obliged to hold much more capital to help absorb losses in case of another crisis.

Banks have only three ways to increase capital relative to their loans and other assets: raising more of capital, cutting costs, or trimming lending and investment. Banks have a strong incentive to limit long-term loans because regulators require them to hold more capital and fund long-term loans in part with long-term borrowing.

Consequently, bank lending to businesses worldwide gets lower while bank lending to consumers yet shrank by less because most of the lending consists of mortgages. Due to this, it provides shadow banks with void to enter, which is time-efficient and worthy for Hall& wood House.

The money of M&G is gathered from institutional investors to be lent to mid-sized British businesses. The investors in return could obtain all the profit yet should bear any losses. M&G works as a matchmaker and only charges a service fee. From regulators’ perspective, Shadow banking makes the financial system safer because any loss will fall on the institutional investors.

Besides shadow banking, the business of “direct lending” or “private debt” is also benefiting from the banks’ retrenchment. Bond markets, another form of non-bank lending continue to grow as bank lending shrinks and the value of bond outstanding almost doubles its value last year. Money markets in the rich world dropped and maintained unrecovered, but they are growing in china and other emerging markets.

Peer-to-peer lenders, known as the websites that match savers with borrowers, are also growing. The emerging new firms provides bunches of services from short-term loans for property developers to advances against unpaid corporate invoices. Shadow lending, excluding insurance and pension funds, is believed to account for around a quarter of all financial assets, compared with about half in the banking system by the Financial Stability Board (FSB). According to FSB, shadow lending has grown rapidly in recent years. It’s confirmed that sorts of shadow lending that worry regulators have atrophied, whereas the sorts pleasing regulators have rocketed.

The process of shifting lending out of the banks and into other financial institutions has long been underway in America. The combination of stricter regulation and increased competition is also hurting banks in some areas such as payment. Since the regulators limit the transaction fee charged by banks for credit and debit cards and new payment technologies are springing up, banks lost its position in the payment process.

Banks are also losing position in the area of trading bonds and other financial instruments in the face of new technology, new rivals and new regulatory constraints. Rules preventing banks from trading on their own account and making trading for others more costly by increasing capital requirements led to less bank’s bond holdings. Regulators aim to reduce banks’ influence over the derivatives and physical commodity business.

At this moment, other financial institutions are grabbing trading from banks. The asset managers are creating systems to trade by themselves. Their electronic trading is also bolstering exchanges, technology firms and data providers. In addition, asset management grow faster outside banks as banks sell their asset-management arms to raise money out of regulation designed to protect investors from conflicts of interest. The new technology makes it easier for firms and individuals to invest and trade without the bank. All these evidence indicate that banks’ business weight in the financial system is diminishing as the regulators intend. They want to see banks shrink and welcome the transfer of risky assets to other parts of the financial system.