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Impact of Regulation on Shadow Banking


1. Abstract

Shadow banking is a global financial system responsible for creating credit through unregulated channels by organizations that are subject to government regulation. This system has grown significantly within the asset management industry since 2008 and has yet to see any direct regulation applied to this sector. The overall lack of regulation on shadow banking presents many risks stemming from poor consumer protection standards, lack of transparency into transactions performed by asset managers along with a larger global concern that shadow banking could be the cause of another financial crisis. Due to this, the focus of this research is to know the impact of regulation on shadow banking in Europe and how it will affect the asset management industry’s data and reporting standards. Throughout the course of this research, interviews and a survey will be conducted to gain feedback from experts in the asset management industry while also analyzing financial data on this sector. The report will then seek to identify a process and course of action for asset managers to improve data reporting quality within the shadow banking system in order to provide transparency and prevent a negative shock to the global financial market.

3. Introduction

In 2007, the shadow banking sector is stated to have reached its peak of $25 trillion worldwide. This figure reportedly decreased to approximately $24 trillion worldwide in 2010 and has since climbed to a high of $67 trillion worldwide (Marriage, 2015). However, estimating the exact size of the shadow banking and non-traditional banking sector is assumed to be difficult. Many entities who participate in shadow banking and non-traditional banking do not report to government regulators and thus operate off-the-record. The shadow banking system has grown to be considered equal in size to the traditional banking sector, which presents the importance of non-traditional banking.

Traditional banking is commonly thought of as a ‘commercial bank.’ The average consumer knows a brick and mortar building with bank tellers who help to deposit checks and withdraw cash. The traditional banking business was initially established to issue long-term loans and in return, receive short-term deposits to create a steady revenue stream (Sengupta & Noeth, 2011). Banks have always had a large influence on both the global financial system and on world economies, which is a reason they are highly regulated. However, “the profitability of traditional banking…has diminished in recent years. As a result, banks have increasingly turned to non-traditional financial activities as way of maintaining their position as financial intermediaries” (Mishkin & Edwards, 1995). In addition, traditional banking is susceptible to risks and crises, which was realized in the 1930’s with the Great Depression and with the sub-prime mortgage crisis in the 2000’s. As a result, these banking crises attempt to be mitigated with financial regulation issued by government authorities.

In contrast, the non-traditional banking system, such as the shadow banking sector, arose in reputation as a result of the sub-prime mortgage crisis in 2008. During this period, shadow banking became noticed in the United States due to the “growing role in turning home mortgages into securities. The ‘securitization chain’ started with the origination of a mortgage that then was bought and sold by financial entities…used to back a security and sold to investors. The value of the security was related to the value of the mortgage loan…and the interest on a mortgage-backed security was paid from the interest homeowners paid on their mortgage loans” (Kodres, 2013). This entire process was kept out of sight of regulators and conducted ‘under-the-radar.’ The process would have continued to function, however during the global financial crisis, investors grew weary of how much their assets were truly worth and chose to withdraw their funds. Shadow banks were forced to sell assets in order to repay their investors, which in turn lowered the price and the value of assets across the market. This caused doubts about the value of the market, which led to investors removing their funds all together, resulting in both traditional and non-traditional banks to be left with extreme issues in the United States and the rest of the world. Due to the fact that these funds were handled by numerous parties with very little transparency or clear reporting, it was also unclear as to who owed whom what money and when.

The global financial crisis left a poor reputation on this non-traditional banking system. Shadow banks became known for their overall lack of transparency and need for government regulation to prevent similar issues from occurring. Currently, world economies are now beginning to recover from the recent recession, which brings a stronger need for regulation to be issued among the non-traditional banking sector. In fact, “The number of asset managers lending directly to companies in the US and Europe has more than doubled in the past two years, underlining fears about the rapid development of financial intermediaries known as shadow banks. The 120 per cent rise in the number of fund managers operating direct 12 lending strategies has come as banks have been forced to scale back their lending activities due to regulatory pressure to shrink their balance sheets” (Marriage, 2015). The following essay seeks to combat one of the main issues raised by the financial crisis; the lack of reporting standards, specifically focusing on shadow banks in the European asset management industry.


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