What is shadow banking?

One of the leading factors that caused the financial crisis of 2007 was the risk taking and failure of shadow banks in the advanced countries. Here, many banks remained outside the regulatory control of the central banks. They have taken too much risk and their risk taking tendency was unnoticed by central banks like the US Fed; because these institutions were not regulated. These unregulated entities are called as shadow banks.

Shadow banking is that part of the financial system where ‘credit intermediation involving entities and activities remains outside the regular banking system’.  The term “shadow bank” was coined by economist Paul McCulley in 2007.  After the financial crisis, central banks including the US, UK and EU have introduced many strong measures to control shadow banking. A global institution called Financial Stability Board is coordinating and designing these measures at the request of the G20. The Volcker, Vickers and Liikanen Reports in the US, UK and EU respectively have recommended strong regulation of the sector. 

Shadow banking sector in India

The shadow banking trend was very strong in advanced countries. But they are not that much pronounced in developing countries like India. Still, the risk related to the excessive risk taking and failure probabilities of these institutions may create systemic crisis in India as well. Hence, the RBI is implementing measure to control all financial institutions including the NBFCs (Non Banking Financial Companies). In India, the NBFCs are sometimes categorized as the shadow banking sector, though they are well regulated now. The increasing regulatory measures for NBFCs are an instance for the RBI’s effort to make strong control over the sector.

RBI’s Financial Stability Report (2014) notes that the NBFCs that constitute the shadow banking sector in the country are under regulatory control. “In the Indian financial system what has been reckoned as shadow banking by the FSB are predominantly non-banking financial companies (NBFCs), which have been under prudential regulation for a long time and account for a relatively small share of the total assets of the Indian financial system (FSR, 2014, P, 42, RBI).”

At the same time, it is to be noted that in the context of the developing countries, the shadow banking sector plays an important role in promoting financial inclusion. They are very customer friendly, market oriented, innovative and flexible. The main advantages of shadow banks lie in their ability to reduce transaction costs, their quick decision making ability, and customer orientation and prompt delivery of services. Similarly, in India, the NBFC sector performs an exceptional role in providing credit in the rural areas. Hence, the sector is carefully regulated by the RBI in recent years.