The document discusses shadow banking, which refers to non-bank financial institutions like hedge funds, money market funds, and investment banks that are not regulated like traditional banks. While shadow banking provides alternative funding sources and financial innovation, it also poses risks to financial stability due to loose practices and high leverage. The growth of shadow banking is linked to the 2008 financial crisis. Regulators are now seeking to increase oversight of shadow banking to prevent future crises and reduce maturity, liquidity, and leverage mismatches.

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Shadow Banking
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Shadow Banking
Shadow banking has influenced the global economy even though most of its operations
fall under the unregulated or under-regulated sectors of the financial industry. Despite the fact
that the concept features in policy discussions and new media, there is no consensus in regards to
its definition as outlined by the Financial Stability Board. In some areas, it refers to all non-
financial firms that perform banking functions, but are less regulated or not controlled as
traditional banks (Schiller, 2012). The shadow banking system also has financial agencies that do
not receive deposits from the public. They include hedge funds, pension funds, investment
banks, money market funds, as well as leasing and factoring companies (Plantin, 2015). Asset
management organizations are also categorized as firms in the shadow banking system. Since the
firms are non-deposit taking agencies, the stringent guidelines that apply to the banks do not
affect them. Operations of the organizations are highly risky because of the minimal regulations.
Background and Related Work
The 2008 financial crisis resulted into the collapse of key players in the financial industry
as well as the investment sector. Before the economic meltdown, economies in various parts of
the world had started to experience impacts of the European nations’ sovereign debt crisis. As a
result, financial systems came up with new concepts and terms to sustain economic stability. One
of the concepts that have attracted the attention of the financial market and regulators is the
significance of shadow banking (Simkovic, 2009). In the recent past, discussion papers and
studies that analyzed the functions of shadow banking institutions were blamed for causing the
United States’ sub-prime crisis that lead to the severe financial crisis. Regulators are looking into
the operations of the shadow banking system and bringing them under stringent control to
prevent another financial crisis from occurring in the future.

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In fact, the major concern regarding shadow banking is lack of regulation. In fact, economists,
politicians, regulators and banks are greatly concerned about how shadow banks are managed.
Shadow banks before the 2007 financial crisis grew at a rapid rate similar to that of conventional
financial institutions (Simkovic, 2009). Money market funds, special-purpose entities, and
hedge funds gained from the reduced interest rates provided by central banks. External
companies were utilized by banks to address all the transactions that were considered risky. They
did this with the aim of avoiding these transactions from appearing on their books. As a
consequence, the quantity of shadow banks financial transactions across the world increased
from $ 27 trillion to $ 60 trillion. This growth has compelled regulators in the financial sector to
set up a regulatory framework to oversee the activities carried out by shadow banks.
Home Mortgages and Shadow Banks
Shadow banking attracted the attention of the financial experts because of the essential role they
played in transforming home mortgages into securities. This secularization chain commenced
when a single or more financial entities purchased and sold mortgages. However, these activities
were not controlled by the regulators. For this reason, the Financial Stability Board, an entity of
supervisory and financial authorities from key international financial institutions and economies
designed a wider definition of the shadow banking system. Their definition included all entities
excluded from the regulated banking system although they carry out key banking activities such
as credit intermediation. Intermediation is defined by four aspects including maturity
transformation, liquidity transformation, leverage, and credit risk transfer. Maturity
transformation entails acquiring short-term funds with the primary objective of investing in long-
term assets while liquidity transformation involves utilizing cash-like liabilities to purchase
harder-to-sell assets including loans. Leverage, on the other hand, entails applying various

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strategies such as borrowing cash to purchase fixed assets to expand the potential benefits of an
investment while credit risk takes the risks of the borrower defaulting to pay loan and
transferring it to another party from the owner of the loan.
Analysis of the Shadow Banking System
As non-deposit taking entities, shadow banking firms generate cash by offering services
to as financial institutions, corporates, and households. Funds that accrue from the liabilities are
then utilized to develop assets such as auto loans, mortgages, and other long-term assets
(Subramanian, 2013). The functions are also performed by banks, but the difference is that
shadow banks utilize non-deposit liabilities that are highly liquid and short term in nature.
Besides, a majority of shadow banks are highly leveraged, making them vulnerable to financial
crises. In contrast, banks enjoy public or regulatory support that guarantees them protection
through deposit insurance facilities and central banks. Since shadow banks do not have any form
of liquidity support, they are subjected to systemic risks, especially in times of crises or when
experiencing liquidity challenges (Plantin, 2015).
Methods
The research makes use of both quantitative and qualitative research methodologies to
explore the topic. The aim of using quantitative research is to provide the target audience with a
numerical analysis of the entities that exist in the shadow banking system and their performance
with regard to generating revenues. In contrast, qualitative research methodologies are used for
gathering in-depth information on the characteristics and operations of the shadow banking
institutions. The data is collected from secondary sources such as websites of reputable
organizations.
Results

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From the analysis of various literatures, it is evident that shadow banking systems
significantly differ from conventional banks in various ways. To start with, their operations are
not done under regulatory supervision by government agencies and central banks. As such, they
conduct activities under different leverage, liquidity, and capital guidelines. Secondly, the do not
receive support from the government. Even in times of financial crises, central banks do not offer
them liquidity support to sustain operations (Subramanian, 2013). The lack of access to resources
such as credit backstops and government liquidity makes shadow banks inherently fragile.
The activities of the shadow banking system have both negative and positive impacts on
the financial system. On the positive side, they provide the needy with an alternative source of
funds for investments. They also facilitate extension of credit to various sectors, especially small
and medium enterprises that are not served by conventional banks. Shadow banks also provide
investors and financial institutions with various instruments to control credit risks (Subramanian,
2013). Thus, they reduce the cost of financing and contribute to growth of economies.
Despite the benefits, the shadow banking system poses threats to financial systems’
stability. Since they are not controlled through sound regulatory and safety procedures, it is
evident that they expose the public to financial risks. Most of them are characterized by loose
practices because they aim at generating income rather than sustaining the stability of economies.
They offer clients risky and non-transparent financial products, which cannot be accessed in
conventional banks. Accordingly, their financial leverage is high because they use the strategy to
accrue profits when the economy is booming.
There are various strategies that can be used to limit risks that are associated with the
operations of the shadow banking system. Some of them include improving banking regulations
and formulating stringent rules to control money market funds and credit rating agencies

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(Plantin, 2015). Given that shadow banking is dominant in many nations across the world, it is
important to establish a global organization that oversees cross-border transactions. Additional
company level disclosures need to be improved to ensure that firms operate in a transparent
manner. Regulating shadow banking systems is also essential to reduce mismatches in maturity
and liquidity and risky accumulation of leverages (Schiller, 2012). Even though balancing
between safeguarding investors and financial stability and ensuring that shadow banks provide
credit to areas that are not served well by conventional banks is quite difficult, measures should
be taken to prohibit the entities from causing another financial crisis.
Conclusion
The shadow banking system has financial agencies that do not accept deposits from the
public. They include hedge funds, pension funds, investment banks, money market funds among
other companies. The system has both costs and benefits to the economy of every nation. One of
their advantages is that they make credit accessible to more sectors. They also provide investors
and banks with various tools to control credit risks. Furthermore, they reduce cost of financing
and promote financial innovation. However, they pose threats to the stability of financial
institutions because their operations are not regulated. Prevention of economic crises that may be
caused by shadow banks requires scrutiny of the institutions’ activities.

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References
Plantin, G. (2015). Shadow banking and bank capital regulation. Review of Financial Studies,
28(1), 146-175.
Schiller, R. (2012). Finance and the good society. Princeton, NJ: Princeton University Press
Simkovic, M. (2009). Secret liens and the financial crisis of 2008. American Bankruptcy Law
Journal, 83, 253-260.
Subramanian, A. R. (2013). Shadow banking and aftermath of financial crisis - An impact
analysis to address the emerging challenges. Amity Global Business Review, 8, 74-79.