The term shadow banking is to refer to bank-like activities (mainly lending) that are not part of the conventional banking industry. It is commonly called market-based finance. Shadow banking has the same purpose as conventional bank loans. However, it’s not controlled in the same manner as traditional banking lending. Some examples of organizations that participate in shadow banking include:
Money market funds
Special purpose entities.
How Does Shadow Banking Work?
In the traditional way of lending the amount of loan a bank can offer is correlated with the amount of deposits that the bank receives as well as the amount it can take out on the market. Shadow banking is based using the same principles. For instance, an investment fund will take from investors and invests it and then issues shares to the fund in exchange. To earn a profit on the investment of its investors, the fund makes use of the money to purchase securities (for instance bonds issued by a nation or a company).
As the bank functions as a “middleman” between the savers as well as lenders to get a certain interest rate and the investment fund serves as a conduit between the investors with companies/countries to earn the investment returns. Through obtaining funds from investors and loaning this money to companies or countries shadow banking entities behave as banks.
How Does Shadow Bank Function?
Shadow banking is primarily concerned with financial institutions that are not banks involved in the process of maturing. For instance, commercial banks finance long-term loans using deposits which are usually short-term, they participate in maturity change. Similar is the case for shadow banks. In the money markets, they usually take short-term loans or raise funds that they then use to buy assets with longer durations.
However, since the traditional bank regulations don’t apply to them, they are unable to access funds at the Federal Reserve in a time of need. Additionally, they do not have traditional depositors whose funds are protected and, as a consequence, they operate in the shadows.
Broker-dealers who use repurchase agreements to pay for their assets will be included in the sphere of shadow banking. Repurchase agreements are where an entity in need of funds sells a security to get the money needed and promises to purchase the security back at a predetermined price and at a specific date to repay the loan.
Shadow banks also comprise money market mutual funds which pool money from investors to purchase corporate IOUs (commercial papers) or mortgage-backed securities. The same goes for companies in finance that sell commercial papers and make use of the proceeds to give credit to homeowners.
Pros And Cons:
Pros of Shadow Banks:
More loan options: They have different lending options and other methods of financing, which makes credit more accessible for both business and private individuals.
Lower costs: They usually have less overhead expenses and provide lower rates of interest and charges than traditional banks.
Flexibility: They usually offer flexible repayment terms and can be more flexible to the changing economic environment.
Faster processing times: They can complete loan applications and release funds quicker than traditional banks.
Cons of Shadow Banks:
There is no regulation for them In most cases, they aren’t under the same level of regulation as traditional banks, which can result in a higher risk for borrowers as well as lenders.
Insufficient protection: They don’t have the same amount of insurance protection that traditional banks do, meaning that lenders and borrowers be more vulnerable to loss.
Opacity: They’re often less transparent than traditional loans and make it difficult for lenders and borrowers to grasp the risk they carry.
Market instability: These could be major cause of instability, particularly when there is a downturn in the economy. It could have an adverse impact on the lenders and the borrowers.