Shadow Banking – Financial Report

Table of Contents Executive summary 1.Definition 2.Attraction. 3.Shadow banking in the world. 4.Effects 4.1 Financial system 4.1.1.Financial system definition 4.1.2.The impact of shadow banking on the financial system 4.2Stakeholder 4.2.1. Stakeholder definition 4.2.2. The impact of shadow banking on the stakeholders

Executive summary

Shadow Banking is a new financial glossary in recent years, but non-banking financial operations have occurred popular for a long time and in many countries. Shadow banking is mature with more than four decades of history in the U.S (industry practitioners of the Hong Kong Chapter of the Institute of Operational Risk and the students from RMBISA of the Hong Kong University of Science and Technology, 2014) After the global crisis in 2008-2009, shadow banking has caught the attention because many experts reckoned that is one of underground factors that will impact the global economy in the future without timely measure. This report provides information about shadow banking. Firstly is definition and overview of shadow banking in the .

1. Definition

Shadow banking is known as a complex network of credit intermediation that provides service similar but outside the border of traditional commercial bank (FSB, 2011). The term” shadow banking“ is attributed in a 2007 by economist Paul McCauley, who coined it at the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming. Normally, the traditional bank is regulated by the Government to ensure solvency by deposit insurance scheme. If the bank is collapsed, the Government will bail out. In contrast, Shadow banking is non- financial institution that acts as a bank but it is not regulated by the Government and it takes the money from short-term and invests into the long-term asset by using of the credit derivatives to avoid the regulatory regime applicable to bank. Examples of shadow banking are hedge funds, insurance companies, crowd funding organizations, private equity firms, special purpose vehicles, and money market funds and others entities that hold financial asset .Financing activities of shadow banking are through investors, borrowing, or creating financial products, different from the traditional commercial bank, it does through deposits.

2. Attraction.

Before, people borrow mainly money from the traditional bank. However, the functions of the traditional bank is collecting the money from depositors who has surplus money and lend to the public who are in need of capital so the amount of loans is limited with a lot of conditions, such as: payment maturities, interest, collaterals… Therefore, people are looking for others alternative lenders, it is when shadow banking starts coming into play. There are 3 factors of the shadow banking’s attraction that shadow banking attracts people more than regulated banks. Firstly, shadow banking offers credit intermediation much greater efficiency and highly than the traditional banks do. Secondly, shadow banking system related with systematic risk and high return so shadow banking is an attraction choice for investor who is seeking high return. By investing in shadow banking, the investors can get a high net interest margin between the controlled and the black market rates. Lastly, on the borrower’s point of view, shadow banking provides source of finance that borrower can easily get into the process and directly lend by the absence of the regulated bank must comply with.

3. Shadow banking in the world.

Following the Financial Stability Board exercise, the shadow banking system has grew by leaps and bounds from $ 26 trillion in 2002 to $ 62 trillion in 2007, decreased to $59 trillion throughout the Great Depression then got back to $67 trillion in 2011.(FSB, 2012a). Based on the Financial Stability Board’s data, the United Kingdom with , The United States, The Euro Area have the biggest shadow banking system. (Exhibit 1) Exhibit 1: Broad Shadow Banking Measures Source: Financial Stability Board. https://www.financialstabilityboard.org/wp-content/uploads/r_131114.pdf?page_moved=1 Total shadow banking asset in The United States was valued $23 trillion, The United Kingdom was $ 9 trillion, The Euro Area was $ 22 trillion in 2011 and Japan was $ 4 trillion. Compare to 2005, the UK share of total non- bank financial intermediation for 20 jurisdiction and the Euro area raised from 9% to 13%, whereas the US’s share decreased from 44% to 35%. (Exhibit 2) Exhibit 2: Share of assets of non- bank financial intermediaries Source: National flow of funds data As presented in figure 3 the size of traditional banking was growing until 2008, with the exception of a fall in 2005, and then it started to decrease. Besides, shadow banking’s size was growing during the Great Depression period. Although it dropped in 2008 and 2011 but continued rising till 2013. Source: BBVA Research based on Financial Stability Board and International Monetary Fund Shadow banking has been growing speedily among developing market economies, for instance: China. Shadow banking sector of China has rapidly growth after the Great Depression and ranks as the third largest in the world. (Reuters,2014) . the share of China’s shadow banking raised four time between the end of 2007 and 2013, pension funds and insurance companies - grew more than 37 percent year-on-year in 2013 to just under $3 trillion, data released with the report showed, according to the Financial Stability Board. (FSB,2014)

4. Effects

4.1 Financial system

4.1.1.Financial system definition

Financial system is the set of products and services, i.e. insurance, banks and monetary policies which provide by financial institutions and interaction market( pension funds, banks, pension funds, organized exchanges, and others companies…) There are multiple definitions of financial system based on different spheres ( organization, regional and international) that mobilize funds for investment and facilities commercial activity. Financial system plays an important role in the economy, if financial system does not function well, that negatively affected the economic growth. The financial system in the firm is the components of procedures, which consist of verification, recording, and timely reporting of transactions. Firm’s financial system affects the financial activities of the organization. Regional financial system is the system that allows exchanging funds between lenders and borrowers. It comprises of financial markets, financial institutions, and banks. The global financial system includes borrowers, investors, financial institutions such as World Bank, International Monetary Funds, Central banks which is operating in the international economy.

4.1.2.The impact of shadow banking on the financial system

4.1.2.1. Positive effects

Shadow banking system is a non-bank financial entity which plays two main functions as securitization – to create and distribute safe assets, and collateral intermediation – to focus on reducing counterparty risks and assisting secured transactions. So Shadow banking can be seen as a type of regulatory arbitrage that is very beneficial part of financial system in all economics across the world. In developed economies such as : the United States, South Korea, the United Kingdom, Canada, Japan, Australia, Germany, France ,etc. , shadow banking system plays a risk transformation in the economic . In lower developed economies, shadow banking system performs a supplementary role to regulated- banking activities it helps to finance the need of borrowers with the financing conditions where the traditional banking are controlled with regulatory constraints . Shadow banking provides an alternative source of funding and liquidity for corporations and market participants by intermediating credit and boost economic activities. Typically shadow banking does not take deposits from customers, it collects funds from pension funds, insurance companies and ordinary savers to invest into securitization, therefore the source funds of shadow banking is flexibility that satisfy the demand of borrowers. Furthermore, shadow banking provides mobilize funds that means there are many lenders. It helps financial system to avoid probability bankrupts which is the reason of chaotic financial system. Securitization – based on intermediating credit, shadow banking has liability to reduce the transaction cost of operation and improve the stability of financial system. Take China as an example, all most of investors borrow the amount of money from shadows banking to invest into construction industry. By building houses, departments, shopping malls, shopping centers that created jobs and bolster the economy. Besides, the development of construction industry is a motivation of the growth of steel production. Therefore, steel export of Australia also goes up.

4.1.2.2. Negative

However the Financial Depression has highlighted the risk of shadow banking is systematic risk that affects greatly to financial system. Shadow banking does exist on its own; it is a network of interconnection and integration that includes: banks, financial institutions, market participants and subsidiaries. Additionally, shadow banking is lack of transparency that acts like traditional banks but outside the Government’s insurance, so if shadow banking collapse, it will not receive any assistance form the Government that can cause a domino effect across other financial institutions and margins, harming financial system. Shadow banking in China is the best example of domino effect. As the world’s most popular country with 1.357 billion in 2013, it’s one of the largest consumer purchase power in the world. Furthermore, China is the largest trading partner in the world. It became the largest exporter over the world in 2013 with primary products such as: electrical, computers and data processing equipment, optical and medical equipment as well as apparel, fabric and textiles.(FSB,2013) China is a main member in world commodity market and deep trade connections with Western markets and one of the main holders of U.S. debt .That means the economic growth of China plays a significant role in world economy development. When the economics of China is unstable, it sends shockwaves through the financial markets of developing economies and has an effect on the growth of global. These investors’ especially foreign investors which have invested in China suffered vast losses in (Thomson Reuters, 2014) because they cannot take the money back.

4.2Stakeholder

4.2.1. Stakeholder definition

Stakeholders are those who have an effect or may be affected by the business of shadow banking. They include primary stakeholders, secondary stakeholder and key stakeholders. Primary stakeholders are those who may be directly affected, either positively or negatively, by an effort or the actions of shadow banking institution. In some cases, there might be interest conflict inside primary stakeholders because a regulation that has positive effect on one group may have a negative effect on another. For examples: People or groups that are indirectly affected, either positively or negatively, by an effort or the actions of shadow banking are secondary stakeholders. Key stakeholders are those who are important to the operation or can have a positive or negative effect on an effort of shadow banking institution. The key stakeholders might be the director, the funder or line staff of the institution. Basically, stakeholders are every people in financial systems, for example: directors, creditors, Government, employees, shareholders, suppliers.

4.2.2. The impact of shadow banking on the stakeholders

4.2.2.1. Positive effects

Shadow banking provides the various types of loan with low cost for customers because it is unregulated. As we know, traditional bank only make a loan to borrower who are able to pay back the loan on time, so they are using 5Cs: capital, capacity, collateral, character and conditions to analyze the borrower’s credit worthiness. It is very difficult for the individual customers who was bankruptcy before or lack of knowledge about finance to get finance from the bank. In addition, corporates also have difficulty in getting loan from traditional bank if they invest in a high risk project or require for a large amount of money that bank cannot serve. As a result, shadow banking is their choice. They may go straight to the shadow banking to borrow the money through Repos market. Although the activities and functions of shadow banking and bank are separate, shadow banking still impacts on traditional banking. It provides well competition for regulated banks. Nowadays, more and more people choose shadow banking as the source to raise fund instead of regulated bank so traditional bank is losing their customer. Therefore, it motivates banks to renovate their strategies to attract more customers. Furthermore, shadow banking also support traditional bank. Sometimes traditional banking is restricted the limit of ability to serve the customers by the regulation of Government, when shadow banking will come into market and help the financial system to operate efficient by transferring risks outside of the traditional bank system. While shadow banking need support from traditional bank through liquidity to issue related structured products and asset-backed commercial paper to the market, traditional bank depends on the shadow banking for pledging a greater fraction of their portfolios than sensible regulation for example …. Shadow banking provide trust and entrusted loans, wealth management products and bankers ‘acceptance bills as an alternative source of funding to real estate developers and the government financing vehicles in order to build up properties and infrastructure, effectively generating GDP. Moreover, with the help of fund from shadow banking, more projects are satisfied so that it creates more jobs for the community and reduce the unemployment rate.

4.2.2.2. Negative effects

Although shadow banking have a lot of benefit, they also bring negative to the stakeholder. The extension of shadow banking creates bubble markets, such as: the commodities market, the stock market, the real estate market. It is the main reason cause the Financial Crisis 2007-2008 that affect strongly to stakeholders in many ways. Many companies collapsed so a lot of employees lost jobs and customers cut off spending. Besides, Government have to provide out aid loan to save and boot economic and it is limit in controlling the cash flow in the country. Rather, lack of transparency and clarity in activities act as an impediment to the effective conduction of monetary policy. 4.3 Recommendation Although the shadow banking has had negative impacts of human and global economy during the world economic crisis, but nobody can deny the benefits of shadow banking. Shadow banking helps the global financial system to work better by creating abundant source of loans for all sectors of the economy. Additionally shadow banks also support traditional banks to provide debts to stabilize the economy in each country in the world. In my personal opinion, the shadow banking will continue promote its ability to support the economy if the Government limits the lack of transparency in its operations by creating a competitive environment where both shadow banking and traditional bank can compete with each other’s. However, shadow banking have to sign a contract with the Government. They have the right to operate with the policy on their own without the bank license, but they have the obligation to provide information and balance sheet when the Government requires because the risk forecast is too high. After the government’s investigation, if the risk of causing financial crisis was low and removed, shadow banking can continues to operate. Otherwise, shadow banking has to stop immediately when the request of the Government is issued. By this way, shadow banking is still unregulated and Government can predict the risk in the financial system to Conclusion References FRB: Speech--Tarullo, Shadow Banking and Systemic Risk Regulation--November 22, 2013. 2015. FRB: Speech--Tarullo, Shadow Banking and Systemic Risk Regulation--November 22, 2013. [ONLINE] Available at: https://www.federalreserve.gov/newsevents/speech/tarullo20131122a.htm. [Accessed 01 April 2015]. Shadow banking and the economy | VOX, CEPR’s Policy Portal. 2015. Shadow banking and the economy | VOX, CEPR’s Policy Portal. [ONLINE] Available at: https://www.voxeu.org/article/shadow-banking-and-economy. [Accessed 28 March 2015]. The Effects of the Global Financial Crisis on China's Financial Market and Macroeconomy. 2015. The Effects of the Global Financial Crisis on China's Financial Market and Macroeconomy. [ONLINE] Available at: https://www.hindawi.com/journals/ecri/2012/961694/. [Accessed 05 March 2015]. Reserve Bank of India. 2015. Reserve Bank of India. [ONLINE] Available at: https://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=911. [Accessed 02 April 2015]. Shadow Banking in India - General Knowledge Today. 2015. Shadow Banking in India - General Knowledge Today. [ONLINE] Available at: https://www.gktoday.in/shadow-banking/. [Accessed 08 April 2015]. . 2015. . [ONLINE] Available at: https://www.bis.org/review/r130204g.pdf. [Accessed 04 April 2015] 2015. . [ONLINE] Available at: https://www.financialstabilityboard.org/wp-content/uploads/r_111027a.pdf?page_moved=1. [Accessed 20 March 2015]. RiskMinds Asia Conference - Risk Management Banking Event - RiskMinds Asia Blog. 2015. RiskMinds Asia Conference - Risk Management Banking Event - RiskMinds Asia Blog. [ONLINE] Available at: https://www.riskmindsasia.com/blog/Risk-Minds-Asia-Conference/tag/id/Chinese-Shadow-Banking. [Accessed 25 March 2015]. China's shadow banking sector 'growing rapidly, third-largest in world' | Asian Legal Business. 2015. China's shadow banking sector 'growing rapidly, third-largest in world' | Asian Legal Business. [ONLINE] Available at: https://www.legalbusinessonline.com/news-analysis/chinas-shadow-banking-sector-growing-rapidly-third-largest-world/67325. [Accessed 01 March 2015]. 2015. . [ONLINE] Available at: https://www.financialstabilityboard.org/wp-content/uploads/r_131114.pdf?page_moved=1. [Accessed 03 April 2015]. 1

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