IMF report urges regulators to step-up ‘shadow banking’ oversight

"Shadow banking is both a boon and a bane for countries, and to reap its benefits, policymakers should minimise the risks it poses to the overall financial system," said the IMF in its latest Global Financial Stability Report (40-page / 2.28 MB PDF).

The term 'shadow banking' generally refers to the provision of credit either fully or partially outside of the regular banking system. The IMF report analyses the growth in shadow banking in recent years in both advanced and emerging market economies and the risks involved.

According to the report, shadow banking amounts to between $15 trillion and $25tr in the US, $13.5tr and $22.5tr in the euro area, between $2.5tr and $6tr in Japan and around $7tr in emerging markets, where the report said the growth of shadow banking is “outpacing that of the traditional banking system”.

However, the IMF said shadow banking can be beneficial as it “broadens access to credit, especially in emerging market economies, where traditional banking networks often face capacity or regulatory constraints, such as restrictions on lending or on interest rates”.

The IMF said: “In advanced markets, various types of funds have been stepping in to provide long-term credit to the private sector as banks have been lending less. Shadow banks also can improve the efficiency of the financial system by deepening market liquidity and risk sharing.”

“Addressing shadow banking risks involves close cooperation with micro prudential and business conduct regulators,” the report said.

The head of the IMF’s global financial analysis division Gaston Gelos said: “We found that the same factors often seem to drive the growth of shadow banking across countries. Shadow banking tends to take off when strict banking regulations are in place, which leads to circumvention of regulations. It also grows when real interest rates and yield spreads are low and investors are searching for higher returns, and when there is a large institutional demand for ‘safe assets’, for example from insurance companies and pension funds.”

According to the IMF, the global financial crisis showed “there are also risks associated with shadow banking due to their reliance on short-term funding, which can lead to forced asset sales and downward price spirals when investors want their money back at short notice”.

In the US, the IMF said shadow banking accounts “for at least a third of total systemic risk, measured as extreme losses to the financial system that occur with a very low probability, similar to that of banks”. In the euro area and the UK, “their contribution to systemic risk is much smaller relative to the risks arising from their banking system”, the IMF said. “This largely reflects the fact that the latter are still more bank-based financial systems.”

The IMF said in advanced economies, activities traditionally considered “less risky, such as non-money market investment funds”, have been growing the fastest since 2009, rising from 35% to 70% of gross domestic product (GDP) in the US and from 35% to 65% of GDP in the euro area.

However, especially in the euro area, “these funds are now holding a higher proportion of less-liquid assets, such as commercial loans, compared to five years ago”, the IMF said. The organisation said it had observed similar trends in the US.

Bank of England governor Mark Carney, who is also chair of international watchdog the Financial Stability Board, said last December that the growth of unregulated or less regulated 'shadow' banking activities in emerging markets could become the biggest threat to global financial stability if regulatory reform did not take place at the same pace as in more advanced, developed economies.