Got $70 Trillion? The Rise of Shadow Banking

The latest IMF Global Financial Stability Report has some interesting findings about the state of shadow banking, defined by the IMF as "financial intermediaries or activities involved in credit intermediation outside the regular banking system, and therefore lacking a formal safety net." In particular, there are debates about its size due to measurement issues and its consequent implications for--you guessed it--global financial stability. I am particularly struck by Figure 2.3 depicted above which purports to be a simplified representation but has my head spinning. At any rate, what follows are summaries of the findings. For the most part, regulatory arbitrage and the growth of investible funds at a time of loose money policies are driving the phenomenon in the developed world:

• Although shadow banking takes different forms around the world, the drivers of shadow banking growth are fundamentally very similar: shadow banking tends to flourish when tight bank regulations combine with ample liquidity and when it serves to facilitate the development of the rest of the financial system. The current financial environment in advanced economies remains conducive to further growth in shadow banking activities [i.e., low interest rate environments coupled with official intervention in capital markets].
• Most broad estimates point to a recent pickup in shadow banking activity in the euro area, the United States, and the United Kingdom, while narrower estimates point to stagnation. Whereas activities such as securitization have seen a decline, traditionally less risky entities such as investment funds have been expanding strongly.
• In emerging market economies, shadow banking continues to grow strongly, outstripping banking sector growth. To some extent, this is a natural by-product of the deepening of financial markets, with a concomitant rise in pension, sovereign wealth, and insurance funds.
• So far, the (imperfectly) measurable contribution of shadow banking to systemic risk in the financial system is substantial in the United States but remains modest in the United Kingdom and the euro area. In the United States, the risk contributions of shadow banking activities have been rising, but remain slightly below precrisis levels. Our evidence also suggests the presence of significant cross-border effects of shadow banking in advanced economies. In emerging market economies, the growth of shadow banking in China stands out.
• In general, however, assessing risks associated with recent developments in shadow banking remains difficult, largely because of a lack of detailed data. It is not clear whether the shift of some activities (such as lending to firms) from traditional banking to the nonbank sector will lead to a rise or reduction in overall systemic risk. There are, however, indications that, as a result, market and liquidity risks have risen in advanced economies (see also Chapter 1).
• Overall, the continued expansion of finance outside the regulatory perimeter calls for a more encompassing approach to regulation and supervision that combines a focus on both activities and entities and places greater emphasis on systemic risk and improved transparency. A number of regulatory reforms currently under development try to address some of these concerns (see Annex 2.4). This chapter advocates a macroprudential approach and lays out a concrete framework for collaboration and task sharing among microprudential, macroprudential, and business conduct regulators.

My general interpretation is that the banks are always a step ahead of the regulation game in which "more transparency" is always being asked for. Once they manage to comply, the banks are already onto another set of new financial instruments that skirt these regulations. Basel IV...Basel V, Basel VI, etc., soon follow. It is an essential characteristic of capitalism to constantly seek better returns, and if this involves moving into grey areas, banks will naturally do it.