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Pros and Cons of Shadow Banking



The usage of financial services such as banks implies new savings and deposits. Other entities have arisen, however, which combine banking facilities and loans that cannot be listed as banks in their entirety. This have altered the framework of the banking business and have demanded a thorough understanding of this field. The emergence of shadow banking in the market has prompted researchers to investigate the notion of this emerging industry and to specifically categorize its services and activities. This paper discusses shadow banking, illustrates the services available, outlines the pros and cons and illustrates the relation between this modern banking mode and the conventional system (Poszars & manmohan, 2011)

Purpose of the Study

The primary aim of this research is to discuss and explain the definition of shadow banking, I just read your profile and I want to be your pal from Kenya, the core fundamental ideas behind it. The thesis focuses on the implications of this financial structure and the role of shadow banks in contemporary real existence. In comparison to conventional bank types, it describes the connection and location of shadow banking in the future.

Background of the Study

For many years, finance has adopted the conventional banking structure, and has succeeded in the sector amid numerous management and organisational problems. Significant controversies between the financial industries, the government and the people have been the correct financing forms, interest rates and values regulating loans and investments. Some complain that the prices are high, whilst others do not get adequate funds for their needs. On the other hand, the government plays a significant role in managing a balance of payments that is affected by bank exchange rates. The advent of shadow banks has contributed to a broad business debate focused on the foundation of their practises and has at the same time provided answers to the multiple problems relevant to banking unit operations (Adrian & Shin, 2009).

Pros and Cons of Shadow Banking

Literature Review

What is Shadow Banking?

This is a network of financial institutions such as structured investment vehicles, hedge-funds, conduits, money-market funds, investment banks and non-bank financial institutions whose members are not subject to regulatory limits and laws. They facilitate credit creation in a global financial market whose banks are non-depository. These banks do not accept traditional bank deposits and their activities such as credit default swaps are not regulated. As a result most of the instruments are able to fetch higher market as well as credit and liquidity risks despite lacking the necessary capital requirements commensurate with the said risks (Claessens, 2014).

            Operations of shadow banks before the collapse of the market in 2008 entailed borrowing through shot term liquid market, and using these funds to invest in less liquid assets, such as securitized mortgages in the long run without any regulations. However, the collapse of the market resulted to foreclosures of the shadow banks because lenders were afraid of the imminent risks in credit and the institutions could not obtain funds from the collapsing investments which no one wanted to buy. These banks have played a big role in provision of credit and high return despite the great risks involved. However, since the recession and the economic credit crunch, investors prefer more conservative strategies of investments.

The Rules that Banks Can and Can’t Do with Money

Banking institutions function under regulations which govern the usage and collection of funds. What banks can do with the money that it obtains from the clients should be relevant to the running and operations of the bank. This usage relates to many factors among them credit creation and investments. Banks use the deposits to create credit for extra borrowing and through undertaking various risks in investments such as mortgages. Banks also use the funds to offer loan advances to the members. Besides this, funds are used as salaries for staff members and management.

However, despite the amount of funds held in stock, banks are not under any authority to carry out activities that are illegal such as money laundering. They cannot advance loans without provision of securities nor can they misappropriate funds.  Banks cannot squander away the funds available especially through the management nor can they pay their liabilities with the funds from the accounts of the members. In this case banking institutions maintain their assets and accountability by ensuring that they are a going concern. Other institutions that behave like banks as hedge fund, money market funds, off balance sheets vehicles

These institutions that behave like banks such as hedge funds are also not subject to regulations mainly because they fail to accept traditional bank deposits. They are examples of shadows operating with the same measures and taking the same risks. This research classifies these institutions as risky based on the market in which they operate. These banks do not hold any amount of funds as securities for lending, but still channels money from lenders to borrowers. They achieve this through pooling of funds obtained from loan originators and the loan payments are securitized by creating financial instruments.

What Can Shadow Banks Provide?

Shadow banks provide several services just like the traditional banks. Firstly, they advance loans to their clients which do not have securities for a short period of time. These loans can be used to create long run funs and thus fetch high returns in the market. They are a means of employment to several professions such as editors, accountants, mangers and operational level staff. Besides this, they create credit and use this same credit to provide for withdrawals and deposits to members. They offer mortgages and other financial consultancy services such as advising clients and regulating cash flows.

Difference Between Shadow Banks and Banks

There are several differences between traditional banks and shadow banks. The key distinction is that, the traditional banks are subject to regulations so as to ensure a sound financial system, while shadow banks do not follow any form of legislation. Secondly, shadow banks are not supported by the government through deposit insurances to protect their individual bankers whose accounts hold up to two hundred and fifty thousand us dollars against failure, as opposed to traditional banks. Thirdly, banks are required by law to hold a certain amount of capital and they may be cushioned by the federal reserve in case of collapsing. These requirements are however not subject to shadow banks. Fourthly, costly regulations of the traditional banks have led to slow growth as opposed to the rise of shadow banks due to arbitrage from regulation. Shadow banks do not hold a certain amount of deposit as security for loans because they are not subject to any laws. The rates of interest in shadow banks are lower than those of banks leading to more growth.

The Connection Between Traditional Banking and Shadow Banking

Shadow banking and traditional banking are connected through the services that they offer. The two forms of banking act as intermediaries between borrowers and lenders. They provide credit and capital to investors and may operate within the same state. The collapse of the shadow bank market led to regulation being created that reduced the exposure of the normal banks. These related to consolidation rules for purposes of financial prudence and regulations of money market, securitization and repos. The two forms can also interact at both local and international level to operate successfully (Carlsen, 2007).

Regulation of Shadow Banking

 The main reasons for regulating shadow banking are; the first reason is that shadow banking at many times it is used as an escape of regulation. It performs activities which were also done by traditional banks bank system which is regulating thus increasing the probability of systematic risks. The second reason is that several activities which are particular and special to shadow banking encompass credit and liquidity transformation, maturity and high leverage like the traditional banking system thus making it vulnerable to systematic risks and panics.

Regulation of shadow banking is possible but in this case the agenda of the regulation should not focus on restricting shadow banking per se rather the regulation should be dedicated on maximizing efficiencies and reducing factors that may lead to the increase of risk in shadow banking. Shadow banking can be regulated to take full advantage of economic efficiency through correlation of market failures.  The market in our case is the non-bank sector. There are four types of market failures which might occur within shadow banking network; rationality failure, incentive failure, information failure and principal-agent failure. Market failures might be exacerbated by shadow banking, regulation will enhance controlling though it will eliminate completely the failures (Ordenez,  2013).

Regulation of shadow banking should focus on reducing systematic risks which are mainly caused by panics. Regulation will lead to reduction of fragmentation, opacity and interconnectedness by controlling the factors which give increase to shadow banking hence regulatory solution should be based on controlling regulatory arbitrage.

Clearing House

A clearing house is defined as a financial institution that offers settlement and clearing services for transaction of securities, commodities and financial derivatives. These transactions are accomplished on a securities exchange or off exchanges as well as future exchanges in the over the counter markets. A clearing house is a clearing participant which stands amongst two clearing firms. The main purpose of a clearing house is that it reduces the risk of a clearing firm or one failing to meet his obligations of trade settlement.

A clearing house will decrease the risk of settlement by transactions netting offsetting between numerous counterparties by requesting for a margin deposits or collateral deposits and assessing credit worthiness of the firms clearing. They also provide an independent valuation of collaterals and trades, and giving a guarantee that will compensate losses which have exceeded the clearing firms default collateral on deposit.

Once trade has been completed is handed over to a clearing house by the counterparties who are having the exchange or the trade. Novation is the process of transferring the trade title to the clearing house. Numerous clearing houses they do guarantee funds because they are capitalized with clearing firms collateral and in cases where the clearing firms fails to settle an obligation, it will be stated to be default and clearing house default procedures will be used to compensate the party (Freund & Nikola, 2005).

Effects of Financial Crisis on Shadow Banking

Financial crisis affected greatly the operation of shadow banking and this is clearly seen in the case where during the financial crisis period the shadow banking system was under strain which lead to collapsing of many parts or activities they carried out. Unlike traditional banking, shadow banking was assumed to be safe before the beginning of financial crisis by having liquidity backstops which were in the form of guarantees and wraps. It lead to failure of public sector in guarantee support of shadow banking which was caused majorly by relevant parties which underestimated the asset price and aggregate risk. The market did not correlate the valuation price of structured securities which were highly rated during the period of financial crisis than during normal times. The effect was that investors were required to shed their assets so that they could generate the necessary liquidity required to meet the set margin calls (Ojo, 2013).

The Most Famous Shadow Banks

Hedge funds are the most famous type of financial intermediaries. Hedge fund is described as administration of professional management companies of a pooled investment vehicle. They are so different from mutual funds because they employ private equity funds and leverage funds and they do invest in liquid assets.

Hedge funds have a diverse market for investing and it uses variety of financial instruments and investment styles. They cannot be sold to the public but they are only issued to certain accredited or sophisticated investors. They are mainly open ended and they permit withdraw and additions by investors. Numerous hedge fund strategies which are used for investment aim at achieving a progressive return on investment irrespective whether the markets are stable or failing or rising (Frush, 2007).

Future of Shadow Banking

In the future shadow banking will behave like banks without them meeting the requirements of a bank. They offer all service or they will perform of regulated banks. They will supply directly to their suppliers and also hedge funds will likely fall in the public sector.  Due to the increase in regulation of traditional banks which will lead to increase in the transaction rates you will find that many investors are moving to investing in shadow banks as they have low rates hence this will lead to increase in demand so there will be need to form more shadow banks. Due to the increase of investors also the risks of operating shadow banks will increase thus making them increase their rates to accommodate the risks (Longworth, 2012).

Growth of shadow banks might lead to loosening of standards of lending in the future because the traditional banks are struggling to them yet they are not regulated. Shadow banks will tend to charge higher rates in the future because  cost capital which is higher than in the case of traditional banks though they usually enjoy low rates of interest.

Effects of Shadow Banking Going Bust

 If a shadow bank goes bust they will cause an intractable economic problem. Many countries will face defaults of prospects due to conditions of unknown actual value of several operations of debt-laden. This will cause drop in investment and creation of credit crunch.  Also small investors are the ones who will be highly affected because they will not be able to afford to invest in the banks due to the high rates associated with their operations.

 Statistical Analysis

Global flow of funds (GFF) is a conceptual approach which was developed by IMF statistics department. GFF framework uses flow of matrices and external stock to plan claims between pairs of sector locations. Though GFF matrix sums the economy sectors into various categories, there are only two features which make GFF to be informative on the direction of flows and the amount behind the flows. The first feature is that shadow banking is closely tied to the operations of formal banking structure. The second one is that apart from categorizing non-banks as “other Financial Corporations’’ by use of legal procedure of the claim will give counterparty claims in inflows of capital by buying of securitized claims (Gorton, & Andrew, 2010).


Shadow banking plays a great role of diversifying the sources of financing of the economy in a manner which is suitable. For instance, traditional banking does not finance small or medium sized firms unlike shadow banking which mainly finances them. Many companies which have been created they have highly depended on market based financing.  Emerge of shadow banking has its benefits like it has been of great importance to those firms which are at the edge of bankruptcy because it has saved them from dissolving (Longworth, 2012.).

Shadow banking does not pose any risk to the economy like the case of large banks. In the case of market based financing the risks are distributed amongst the pool of sophisticated investors who are able to absorb any type of loss which has occurred.  Investors in shadow banking are not able to withdraw their capital instantly like depositors of traditional banks (Gregoriou, 2006).

It is good to regulate the shadow system so that there is financial stability though we should not forget that regulated banks have high risk so it should be constructed with great care and to ensure that the economic benefits of shadow borrowing are not lost. The economic advantages can be lost through establishment of stifling and inappropriate regulatory policies.

In conclusion, existence of shadow banks is of great importance to the small importance because it enables them to save. Also it is possible to regulate shadow banking considering all the factors affecting it and the impacts of the regulations to the economy. They should be regulated on the basis that the efficiency is maximized and a risks a reduced. The paper has also discussed the relationship between traditional banks and shadow banks.

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