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Does shadow banking exist in India?- I

Jul 10, 2013

The 2008 global financial crisis that shook the entire world was one of its kinds. While it threatened the health of the world economy, the cascading loan defaults and bankruptcies led to a global turmoil. Well, the genesis of the financial crisis was laid by the risks that emanated from the shadow banking system that burgeoned during the heydays. The inter-linkages between the regular banking system and the shadow banking system intensified the concerns.

Shadow banking- demystified

The concept of shadow banking system that gained popularity post the financial crisis implies bank-like activities performed by entities outside the regular banking system. As per definition, such activities include maturity transformation, undertaking credit risk transfer, using direct or indirect financial leverage, activities of securitization and securities lending and repo transactions. Thus, shadow banks are entities which conduct financial intermediation directly, such as finance companies or NBFCs. Globally, shadow banking comprises of (a) Money Market funds, (b) Credit Investment funds, Hedge funds, (c) Finance companies accepting deposits or deposit like funding, (d) Securities brokers dependent on wholesale funding, (e) Credit insurers, financial guarantee provides and (f) Securitization vehicles.

This system stands less regulated than the traditional banking system or at times not regulated at all. The assets (loans and investments) stand risky and illiquid and the liabilities (deposits) are prone to bank runs. That said, such non-bank intermediation when conducted in a prudent manner offers a valuable alternative to bank funding and aids economic growth. But highly levered and credit and liquidity transforming shadow banking system can be highly vulnerable to runs and lead to systemic risks.

Is Shadow banking a double-edged sword?

Shadowing banking does not always operate in grey areas. On the contrary, shadow banking can have its own benefits. It is in fact an indispensable part of any banking system. Shadow banks can be advantageous due to their ability to lower transaction costs, quick decision making capabilities, customer orientation and prompt provision of services. In India, such services are provided by NBFCs. NBFCs complement banks in terms of products and services offered and focus on niche areas of business addressing specific needs of customers. Auto financing companies, housing finance companies and others such as mutual funds, insurance companies, etc provide alternative banking services and serve as a back-up to financial system. These can prove beneficial in crucial times when the traditional banking system or marketing channels fall out of place.

However, on the flip side, unregulated shadow banking system can give rise to systemic risks leading to economic collapse. The complexities pertaining to various products offered by such non-financial intermediaries, if misused, can have disparaging effects on the financial system. The 2008 global financial crisis is a case in point. There was complex chain of transactions, heightened credit supply that created asset bubbles and poor quality loan collaterals that were at the surface of shadow banking. Finally these led up to the US financial crisis.

The Indian financial system was not spared too. During the peak of 2008 crisis, few NBFCs in India ran into severe liquidity issues as they were using short term liabilities to lend to long term assets. Besides such liquidity risks, leverage risks stand pronounced as well. That is because shadow banks have no prudential limits on their borrowings. Moreover, such banks also tend to circumvent regulatory guidelines through their varied credit and investments products. Not to forget, this regulatory arbitrage laid the foundation of the global financial crisis. And last but not the least, shadow banking system carries the contagion risks due to their interconnectedness to the traditional banking system. Since these two systems have inter-linkages both on the liability and on the asset side, contagion risks stand imminent in the event of financial crisis.

Thus, the risks and complexities pertaining to shadow banking tend to overpower the benefits that come with it. While this held true for US financial crisis of 2008, does it stand equally fierce for Indian banking system? We will delve more on this in our subsequent article....

Shadow Banking - Next article | All Articles

Shweta Daptardar-Mane

Shweta Daptardar-Mane, has an MBA (Finance) degree and over five years of equity research experience. She passionately tracks the Banking and Finance industry and follows the macro developments in the economy, particularly the central bank monetary policy. She is deeply inspired by not only Buffett's investment acumen, but also by his infectiously charismatic, down-to-earth persona. Shweta is the contributor to our large cap franchise, StockSelect.

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