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Shadow banking system constitutes of- Financial intermediaries who perform functions similar to those of commercial banks but are not subject to regulatory oversights. Banks provide lending facilities to borrowers, where as financial intermediaries act as a link connecting investors and borrowers. Unlike banks, they do not accept term deposits from the general public. Hedge funds, mutual funds, investment banks, and non-banking financial institutions are some components of the shadow banking system.

Debt Crisis

Shadow banking institutions exploit the prevalent inefficiencies in the regulatory system through financial innovations. Unlike commercial banks, no regulatory body monitors the lending functions of financial intermediaries or aids them in times of distress, which makes them vulnerable to shocks. As they are not required to maintain high reserves relative to their market exposure, they can have a high level of leverage and debt to liquid asset ratio. This poses an enormous threat to the financial stability of an economy.

Pro-cyclicity is another characteristic that makes this system vulnerable. During booms, the leverage rises and during recessions they compel the companies to undergo deleveraging.


Banks often carry out some shadow banking activities themselves or invest in financial instruments of the shadow banking institutions. These inter-linkages give rise to systematic risk concerns.
Differences in tax policies across the globe gives financial intermediaries the opportunity to gain from regulatory arbitrage. Companies in high tax countries restructure their activities to shift them to low-tax countries. Such integration and interconnections across the globe expose them to an even higher financial risk.

China has seen a rapid growth in the shadow banking sector and it appears that two-thirds of its shadow banking lending can be characterized as “bank lending in disguise” resulting from regulatory arbitrage. Fear of this ever-evolving risky sector has forced regulators to tighten their control and take appropriate measures to reduce leverage and speculation in the financial sector. Considered a “regulatory storm” this move has shaken the financial sector and stocks are faring increasingly worse on the Chinese stock exchange.

Debt Crisis

Conclusion:

Shadow banking institutions have boosted the financial sector by increasing liquidity of assets. Being less risk-averse as compared to banks, they are willing to lend to borrowers. Such borrowers otherwise wouldn’t have received credit from commercial banks. They can mitigate the risk that they pose by appropriate and strict measures. For instance, Dodd-Frank Act in 2010 in the USA strengthens the arms of the Federal Reserve. It regulates all institutions of systemic importance. In India too the RBI regulates the functioning of NBFCs but this ever-evolving sector necessitates stricter regulations.

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