Shadow Banking's continuous Rise is risk to Global Stability

Skyline of Chongqing city in China

Shadow Banking has become an unstoppable force

A decade later after 2008 Financial Crisis, the global economy is now waiting for a turnaround. The average world GDP has picked up some momentum. Although, economists from independent rating agencies believe that the double-digit growth for developing economies is yet a few years away. As the economy looks to improves, shadow banking funding seems to the next big threat to the global stability. In a simple language, shadow banking is when you have someone that does banking without being a bank.  Someone takes deposits from people and then lends it out. The concept is similar to a Ponzi scheme. Individuals or group of individuals fund corporates without the jurisdiction of the regulator or the government. When loans from registered lending channels like banks turn to NPAs within a few months, can we imagine the risk which shadow banks take?

Growth in global bond, real estate and money market funds continued to swell the world’s shadow banking sector, a watchdog that coordinates financial regulation for the G20 big economies said in its report. The value of the global shadow banking market increased by 7.6% in 2016 to $45.2 trillion, according to the Financial Stability Board (FSB) Global Shadow Banking Monitoring Report 2017.

According to the report, the $45.2 trillion figure represents 13 percent of the total financial system assets of the 29 covered jurisdictions, which represent 80 percent of the world’s GDP. The report now includes Luxembourg for the first time, bringing the total number of jurisdictions to 29.

Shadow Banking is China's magic wand to prosperity. But, what are the risks?

Also for the first time, the FSB report assesses the involvement of non-bank financial entities in China in credit intermediation that may pose financial stability risks from shadow banking. The reason that shadow banking is popular in China is that the regulated state-owned banks pay lousy interest rates and they only loan to large state-owned companies.  If someone can pay better interest rates and make loans to people that can't get loans through the normal banking system, they can make a lot of money. But, funding comes with risks too. A major default could trigger a domino effect panicking local investors which may, in turn, result in a major financial crisis in China.

China and Luxembourg contributed $7 trillion and $3.2 trillion, respectively, to the $45.2 trillion figure. Public lending may not trigger systemic risk in high capita countries like Luxembourg, Cayman Islands, Netherlands etc. Rich individuals can take risks to multiply their wealth by funding newly incorporated companies. The same system cannot be implemented countries in China, India or Thailand where per capita income is low.

With Chinese economy slowing down, Xi Jinping has tightened the regulation on shadow banking individuals and groups. Chinese daily South China Morning Post reported that the companies that had committed to buying overseas assets are now finding it hard to complete the deals amid China’s financial clean-up of its shadow banking activities and banks’ reluctance to extend loans. China, being a $10 trillion dollar economy may not face not any systemic risk. But, a range of defaults by investors abroad may destroy individual investors and medium-sized corporates.

- Chaitanya Kulkarni

Source - Financial Stability Board