Shadow banking has become a universal phenomenon. In developed economies, shadow banking is to do more with risk transformation through securitization. Whereas in less matured economies, shadow banking supplements conventional banking.
Shadow banks carry out financial intermediation activities, staying away from the regulatory regime. Financial Stability Board (2012) stated shadow banking as the “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. Shadow banks pursue maturity transformation (transforming funds from short-term liabilities to long-term assets) and liquidity transformation (transforming funds gaining from liquid liabilities to illiquid assets). Moreover to this, shadow banks provide credit to the borrowers with the help of at least one intermediary. Shadow banks operate with the private or public backing in the form of a bank or an insurance firm or sometimes a Government guarantee (Gandhi, 2014).
Now the point is how shadow banks are different from conventional banks. Shadow banks as the name suggests are not regulated. These banks cannot create money, amidst conventional banks being depository institutions can. So shadow banks raise funds by way of issuing commercial papers and debentures. As a matter of fact, shadow banks’ liabilities do not enjoy the Government guarantee, which is not the case with commercial bank’s deposits.
The reason behind the emergence of shadow banks is simple and that is presence of regulatory arbitrage. Another reason is market need of innovative financial investments, which could absorb risks and provide higher returns.
It is amazing to know that banks float specialized subsidiary to carry out shadow banking activities and banks are also investing in the financial products floated by shadow banks. If a commercial bank wants to hide specific assets in its balance sheet, the bank may float a Special Purpose Vehicle (SPV) to hold those assets.