The practice of lending to businesses and individuals by financial groups outside of the banking industry, known as Shadow Banking, is currently estimated to be worth $72 trillion globally, almost triple the size it was a decade ago. Businesses that engage in this activity include insurance companies, asset managers, hedge funds, private equity funds, and debt firms to name a few.
However, non-regulatory lending is increasing risks for borrowers operating in markets which are more unstable such as real estate, and those struggling with capacity. For example, in China shadow banking is a broad concern, due to liquidity mismatches in the system, and opaque asset quality.
Shadow banking is also on the rise globally prompting an intervention by The Bank of England governor and chairman of the Financial Stability Board, Mark Carney, calling for more regulation in the shadow banking market. A positive call, which seeks to result in tighter controls and shine a light to those hidden risks on the balance sheets.
What are the reasons behind the growth in shadow banking?
The growth of shadow banking systems can be seen as the result of tighter government regulation, including negative returns and the loss of purchasing power. Governments within both the UK and more recently, China have sought to rein in runaway credit expansion by reducing loan quotas, limiting lending to specific sectors and restricting riskier transactions.
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However, before the Governor of the Bank of England spoke out there has been something of an attitude of denial to shadow banking. Bank management has found it convenient to declare shadow banking activities in which their institutions participate as not requiring regulation.
Banking regulators have been wary of approaching shadow banking markets and they don’t see it as an area which they are accountable for, this cannot go on.
Regulating shadow banks
There has already been attempts to regulate shadow banking institutions within the US. The Dodd-Frank Act, passed in 2010, made provisions towards regulating the shadow banking system, however, more must be done on a global level.
In order to regulate these institutions better, a standard-based commercial lending origination platform can be used, increasing overall efficiency. By combining workflow, document management, analytics, and robust security, the platform enables today’s progressive financial institutions to reduce risk and improve customer experience, while addressing the changing regulatory environment.
The aim of regulations, and its enforcement arm; compliance, is to deliver public assurance of the sustainability, solvency, transparency and honesty of the institutions who manage the financial affairs of individuals and corporations alike. The means to do this is to create a set of regulations that require these institutions to behave, maintain records and provide information on their activities in ways that underpin this objective.
The need for regulation within shadow banking is clear, however, implementation requires a thorough understanding of how to create and deploy processes. These are specifically designed, with appropriate controls, to help businesses to comply with regulations without imposing an onerous load on normal business activities.
Now is the time to act to bring this sector into the public gaze and to regulate it appropriately, ensuring that shadow banking activities are both transparent and cannot create problems that jeopardise mainstream banking, public security and the global economic stability.
Hugh Morris is VP for Banking and Financial Services, Genpact