Discusses briefly shadow banks, their role in the subprime crisis, their activities in China, and the regulations and measures taken to control or reduce the negative effects of those financial institutions on the world economy.

1. NOTRE
DAME
UNIVERSITY
–
LOUEIZE
Faculty
of
Business
Administration
&
Economics
Department
of
Accounting,
Finance
&
Economics
ECN
431
–
International
Economics
Shadow
Banking
Mechanisms,
Development,
Role,
Advantages
&
Risks
Submitted
to:
Dr.
Louis
HobeikaSpring
2014
Prepared
by:
Mansour
Assaf
ID
2008
1318
Melissa
Moubarak
ID
2010
1887
Sami
Abou
Slaiby
ID
2010
2645
Yara
El-­‐Kassis
ID
2009
3862

2. 2
ABSTRACT
Shadow banking sector has significantly increased in size during the recent years. This paper
discusses the definition, mechanisms, types of transactions and the intermediaries who interfere
in the shadow banking system. Then, it exposes the benefits of shadow banks whenever they are
well structured and properly managed, along with the underlying risks to which the global
economy is exposed when they are not regulated properly. After discussing the subprime crisis
of 2008, and the role that the shadow banks played in it, it was necessary to describe the shadow
banking system in emerging markets since those countries are exposed to risks from shadow
banking activities, especially since their regulations and control over their activities is almost still
being developed. For that, we will mainly focus on the most prominent emerging country, China,
where shadow banks have grown rapidly along with the risks posed by that growth and the new
exposure to such activities. The last part discusses the regulations that are taken to limit the
growth of this system, their effectiveness and their limitations.

3. 3
TABLE
OF
CONTENT
I.
What is Shadow Banking?.....................................................................................................10
1.
Definitions ..........................................................................................................................10
a.
Activities outside the Banking System ...........................................................................10
b.
Activities that need a backstop....................................................................................10
2.
Activities commonly referred to as Shadow Banking........................................................11
3.
Mechanism of Shadow Banking.........................................................................................11
4.
Shadow Risks .....................................................................................................................14
5.
Benefits and costs...............................................................................................................15
a.
Benefits ...........................................................................................................................15
b.
Costs............................................................................................................................15
II.
Shadow banking and Global Financial Crisis........................................................................17
III.
Shadow banking in Emerging Markets .................................................................................20
1.
Characteristics & Role in Emerging Countries ..................................................................21
2.
Characteristics of Shadow banking risks in EMDEs..........................................................21
3.
Shadow banking system in Central and Eastern Europe and East Asia.............................21
4.
Shadow banking in China...................................................................................................22
a.
China’s Shadow Banking System components...............................................................23
b.
China’s Shadow Banking during the Credit Crisis .....................................................23
c.
Key concerns...................................................................................................................25
d.
Measures taken by Chinese Authorities:.....................................................................25
IV.
Regulatory Reform ................................................................................................................27

4. 4
Introduction
“If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck—or so the
saying goes. But what about an institution that looks like a bank and acts like a bank? Often it is
not a bank—it is a shadow bank” (Laura E. Kodres).
Bank’s activities are bound to obey to strict regulations in order to prevent the excessive risk-
taking, to provide safety to investors as well as depositors. Properly structured, and with risks
properly managed, the non-bank financial institutions with their intermediation activities can
provide benefits to investors, borrowers and the economy as a whole. However, the financial
crisis proved that certain non-bank activities and their interconnectedness with the regular
banking system might pose systemic risks, especially if those risks are not managed and
mitigated effectively.
The central message from this paper is to present shadow banking from its different perspectives,
its relationship to the global financial crisis and the risks it currently poses to the global
economy, and how these risks are controlled through wide-spread regulations.
Since it occurred that our all the group is majoring in finance, we have chosen this topic to first
helps us understand better the systemic risks built in the economy in the absence of proper
regulations and control, to learn more about the relation between international economics and
international finance and how they interrelate. The research on shadow banking helps us also
understand how shadow banking has contributed to the global financial crisis and the lessons
learned from that historical economic disaster that will be remembered for decades to come.
Making research on this topic sheds lights on the instruments used in banking and non-banking

5. 5
sectors, along with the associated risks of each of those instruments. Moreover, we understand
the interactions between markets and different players in the global economy.
After reading many academic papers, reports by international organizations and recent news, we
summarized our findings in this paper. We looked for charts from trusted sources that illustrated
well the subject. The main source of information was the “International Monetary Fund” (IMF).
We took information from the academic papers and reports with their accompanied statistics and
charts.
This paper will show the different aspects of the “Shadow Banking” system, its costs and
benefits. In later sections, we explain how the growth of Shadow Banking sector contributed to
the latest credit crisis. After that we take a look at the shadow banking in emerging markets, its
size and its risks. Then we focus on China, where the estimated size of the sector has reached,
according to some specialists, “worrying size” and may pose threat to the global economy. With
this growing size of shadow banking, some serious measures and regulations must be taken to
prevent the accumulation of risks built in the shadows. Some authorities have to step in to treat
the reasons behind the rapid growth of this sector, and limit the intervention of regulated banks
in the process to prevent the potential risks on deposits in this regulated sector, which is where
the Basel committee stepped in. These regulations and measures are discussed briefly in the last
section.

6. 6
Short
Literature
Review
Before exposing a topic, the definition of the concept should well be understood. shadow
banking is well defined in the following article:
Ø The first reference is an IMF working paper written by Stijn Claessens and Lev Ratnovski
entitled “What is Shadow Banking”. This paper defines shadow banking in different
perspectives, describes its activities and categorizes them between banking and non-banking
intermediation, and suggests the policy implications of these activities.
The mechanisms used by the shadow banking system are diverse and the intermediation
has many aspects, which are shown in these articles.
Ø The second reference is a paper written Zoltan Pozsar and Msanmohan Singh, entitled
“The Nonbank-Bank Nexus and the Shadow Banking System” interprets that the Shadow
Banking is largely an interbank phenomenon through the analytical framework of Banks and
Non-Banks. It describes how the demand and supply aspects of the asset management
complex determine together the shadow banking system, and how asset managers act as
ultimate sources of collateral in this system. They describe how it results in reverse maturity
transformation of non M2 types of money composing the money demand aspect: long term
savings are transformed into short term funding. Securities are lent out for use in the shadow
banking system that becomes collateral intense, when dealers don’t care about its source,
they only care about meeting the demand coming from the need to settle trades with other
dealers through rehypothetication (defined by “Investopedia” as The practice by banks and
brokers of using, for their own purposes, assets that have been posted as collateral by their
clients). As a consequence, a single piece of collateral may serve to underpin various

7. 7
financial transactions. Collateral comes in many forms, the most valuable are re-used as a
system lubrication, but build up the leverage like collateral chains between banks and asset
managers.
Ø The third reference is a paper written by Stijn Claessens, Zoltan Pozsar, Lev Ratnovski,
and Manmohan Singh entitled “Shadow Banking: Economics and Policy”, explains in
details the two main processes of Shadow Banking: Securitization and Collateral
Intermediation. Shadow Banking starts by the Securitization, which is the creation of “safe”
assets from debt obligations to transfer their credit risks, held by Commercial Banks and
institutional cash pools. Perceived as “safe”, they lead to unstable expansion of leverage, thus
market failures and the fragility of the short-term funding. The process of securitization
includes a reverse maturity transformation. Collateral Intermediation is likely to become
more important over time, even though it holds many risks. Liquidity exposure of dealer
banks arises when the prime brokerage clients request back their collateral, and when the
dealer banks are also depository institutions. Shadow banking is a complex ecosystem; it
combines multiple non-bank agents linked with traditional banks using the services of dealer
banks, through two processes: Securitization Chains and Collateral Chains. Moderately strict
policies need to be elaborated in a way that does not remove the Shadow Banking System as
whole, but to reduce its size, preserving its economic positive aspects. Shadow Banking has
its useful economic functions and they are to be preserved by establishing multifaceted
policy response to reduce its size so it can perform its role in a safer way.
Ø The fourth reference is a paper written by Swati Ghosh, Ines Gonzalez Del Mazo, and İnci
Ötker-Robe, entitled “Chasing the Shadows: How Significant Is Shadow Banking in
Emerging Markets?” shows the significant challenges with data availability, size and nature
of Shadow Banking in Emerging Markets and Developing Economies (EMDE), where they

8. 8
are even less discussed and understood. Even though Shadow Banking does not involve
intermediation as in advanced economies, it can pose systemic risks directly – as system
grows – and indirectly through its interconnectedness to the banking system. Policy makers
should insure that the Shadow Banking provide alternative but safe sources of funding to the
private sector. The risks include: potential of excess leverage, amplification of procyclicality,
instability of wholesale funding and potential bank run, regulatory arbitrage &
circumvention. Moreover, the main risks in EMDEs lie in the fact that the activities banks are
engaged in, the riskiness of these activities, how they are linked to the banking sector and
how they are regulated. In EMDEs shadow banking in poorly regulated or not regulated at all
making it and its actors difficult to track. Although relatively small in EMDEs, Shadow
Banking has grown rapidly, inciting the People’s Bank of China (PBOC) to introduce
measures allowing the economy to benefit from its advantages (alternative lending), while
delivering more safety to the financial system.
Shadow Baking has had a major effect on the financial crisis that started in 2007 and
reached its peak in 2008. Several articles and studies were considered to write the effects of
the shadow banking on the financial crisis.
Ø The fifth reference is an article written by Laura Kadres entitled “What is Shadow
Banking” and published on the International Monetary Fund website was used to understand
the essence of shadow banking. This article demonstrated the characteristics of the shadow
banking and the main paths that it may lead to.
Ø The sixth resource is the working paper written by Lysandrou Nesvetailova entitled: “The
Shadow Banking System and the Financial Crisis: a Securities Production Function
View”. This paper showed that the shadow banking amplified the impact of the financial
crisis but it did not cause it.

9. 9
Ø The seventh reference is the article written by Joel Havemann entitled: “The Financial
Crisis of 2008: Year in Review 2008”. This reference was used to look at an overview of the
financial crisis. It discusses the time of the crisis as well as how it folded and pinpoints some
international repercussions. An additional reference that was used to understand the financial
crisis is the article found in The Economist titled “The Origins of the Financial Crisis”.
Ø The eighth reference is a report written by Adam Ashcraft entitled “Shadow Banking: a
Review of the Literature” Presented to the Federal Reserve Bank of New York. It presents
preliminary finding on shadow credit intermediation. It shows the reasons behind the rise of
shadow banking and its relation to the 2008 crisis.
Ø The ninth reference is the article entitled “Why did Chinese Shadow Banking Surge after
2009” written by Joe Zhang. It explains the origin of China's shadow banking to financial
repression, which includes the artificially low interest rate in China.
Since the shadow banking puts the financial system at risk, there is an urgent need to take
the correct measures to prevent future crisis
Ø The tenth reference is the article written by İnci Ötker-Robe and Ceyla Pazarbasioglu
titled “Impact of Regulatory Reforms on Large and Complex Financial Institutions”. It
discusses how we can implement or enforce new regulations on shadow banks and
commercial banks without negatively affecting or crippling the growth of the economy. It
delves into proposals presented by the Basel committees, and how they are to be
implemented, their advantages and their deficiencies as well.

10. 10
I. What
is
Shadow
Banking?
The economist Paul McCulley created the term “shadow banking”. In general it has been very
difficult to define the term “shadow banking” because of its shallowness.
1. Definitions
a. Activities
outside
the
Banking
System
Financial Stability Board (FSB) (2012) describes shadow banking as “credit intermediation
involving entities and activities (fully or partially) outside the regular banking system.” This is a
useful benchmark, and has been much used but this definition has two weaknesses.
Ø First, it may be covering entities not commonly thought of as shadow banking, like leasing
and finance companies, credit-oriented, hedge funds, corporate tax vehicles, and others, yet
that do also intermediate credit.
Ø Second, it describes shadow banking activities as operating primarily outside banks.
However, in practice, many shadow banking activities (liquidity puts to securitization SIVs,
collateral operations of dealer banks, repos, etc.) operate within banks, especially systemic
ones.
Both of these reasons make the description less insightful and less useful from an operational
point of view (Claessens & Ratnovski, February 2014).
b. Activities
that
need
a
backstop
In order to improve the approaches and definitions, shadow banking may be described as “all
financial activities, except traditional banking, which require a private or public backstop to
operate”. This describes many of the activities cited in the next section. (Claessens & Ratnovski,
February 2014).

11. 11
2. Activities
commonly
referred
to
as
Shadow
Banking
A functional alternative approach is presented below, showing the main activities that shadow
banks undergo.
Ø Securitization: trenching of claims, maturity transformation, liquidity “puts” from banks to
SIVs, support to par value money funds.
Ø Collateral services, which are mainly conducted via dealer banks, include the following:
supporting the efficient re-use of collateral in repo transactions, for OTC derivatives and in
prime brokerage; securities lending.
Ø Bank wholesale funding arrangement, including the use of collateral in repos and the
operations of the tri-party repo market
Ø Deposit-taking and/or lending by non-banks, including that by insurance companies and
bank-affiliated companies.
The second definition is likely to capture the activities that might become shadow banking in the
future. In fact, some activities are recently described as Shadow Banking, such as the more
recurrent use of Real Estate Investments Trusts (REITs), leveraged finance, and reinsurance in
the U.S. fall under this definition (Claessens & Ratnovski, February 2014).
3. Mechanism
of
Shadow
Banking
The procedure lies mainly on maturity transformation. Commercial banks participate in maturity
transformation when they use short-term deposits to fund long term loans. Shadow banks do
alike. They borrow short-term funds from the money markets and use them to purchase long
term assets. However, shadow banks are not regulated like commercial bank so they cannot rely
on the Federal Reserve in case of default, in addition to the noninsured funds; they are in the
“shadows”.

12. 12
The shadow banking system contributed to the overall leverage of the financial system. The new
financial participants that developed their activities in this context (SIVs, ABCP conduits,
monoline insurers) were highly leveraged. For instance, a Collateralized Debt Obligation (CDO)
with an equity tranche covering the first 3% of losses represents an investment in the underlying
assets that is leveraged about 30 times. Monoline insurers, depending on the measure used, were
leveraged 50 to 100 times. They fostered the expansion of the shadow banking system by
providing financial institutions with protection in the super-senior tranches of Asset Backed
Security (ABS) CDOs, which is far from their traditional business.
Figure 1: The Shadow Banking System Instruments
According to Financial Stability Board (FSB), shadow banks are individuals who are external to
the regulated banking structure who execute the central job of banking, that is, taking cash from
investors and providing it to debtors. This is known as credit intermediation that has four
significant features:
Ø Maturity transformation: earning money market funds to finance them in long-term assets.

13. 13
Ø Liquidity transformation: using money comparable to liabilities to purchase inflexible and
durable assets that are hard to be sold like mortgages.
Ø Leverage: adopting methods resembling to borrowing cash to buy fixed assets to expand the
possible gains or losses of speculations.
Ø Credit risk transfer: transmitting the risk of the borrowers from the initial investor of the
loan to another party.
Below this classification, shadow banks consist of brokers and dealers supplying their assets
through repurchase agreements (repos). This procedure consists of individuals who need
immediate liquidity, sell a security for a certain purpose and purchase it back as per a stipulated
agreement on a stated day. Money market mutual funds that group the funds of investors to buy
commercial paper or mortgage-backed securities are as well similar to shadow banks.
Consequently, it represents also the financial institutions that sell commercial paper and use the
earnings to lengthen credit to households. Figure 2 illustrates these participants in the shadowy
complex process.
Figure 2: The Participants in the Shadow Banking System

14. 14
4. Shadow
Risks
As long as financers comprehend all the essentials activities and avoid too much of unjustified
risk to the financial scheme, there is none of mysterious things about earning cash from investors
who might want their money later on within a short period of time and capitalizing those funds in
assets with long-term maturities.
However, problems get up throughout the global financial crisis recently. Investors became
nervous about what was the value of long-term assets in reality. After that many decided to take
out their funds. This generated a big conflict; shadow bank had to sell, at a reduced price, assets
in order to repay these investors; this is called “fire sales”. At the peak of the disaster, numerous
of investors withdrew or would never desire to reinvest their funds in financial institutions like
banks and in nonbanks while they are facing thoughtful trouble. Conversely, if this had taken
place separately to the banking system, it could have been the one and only one faced to
shadowy and could have been shut down in a good manner. But real banks were also caught in
the shadows. Therefore, some shadow banks were measured by commercial banks and were
saved by their solider bank parent for reputational reasons.
In other circumstances, these networks were at arm’s dimension, but because of the very little
transparency, it was frequently uncertain who owed or would owe later, what to whom. All these
issues were hard to precise. In other words, shadow banking is described by a deficiency of
disclosure and information about the true and accurate value of their assets.
The authorized segment is gathering further and superior information and examining for unseen
weaknesses. Banking managers moreover are observing the disclosure of traditional bank to
shadow banks and trying to comprise it through such paths as capital and liquidity regulations
because this disclosure permitted shadow banks to disturb the traditional financial segment and

15. 15
mostly the economy. Likewise, because many shadow banking entities were informally regulated
or exterior from any regulation or authority, the consultants are planning for a growing of the
scope of information meant both for entities and the market they use. The authorities are making
sure that all shadow banks’ activities are well managed and directed to avoid and discourage
shadow banks from adopting their actions unless if they are supervised by regulators nationally
and worldwide.
5. Benefits
and
costs
In general, despite the risks lying behind shadow banking, it is agreed that the financial
intermediation through nonbank channels offers some benefits to the financial system:
a. Benefits
Ø Alternative to bank deposits for large investors: Institutional investors rely on shadow
banking rather than the traditional system relative to the large size of the cash pools they
hold. They channel resources efficiently towards specific needs.
Ø Alternative funding for the real economy: In case the traditional banking or market
channels become momentarily impaired, like during the credit crisis, shadow banks can also
provide the funding and the risk diversification. They can make credit available to the sectors
that might not be eligible to credit, providing investors as well, with a range of tools for the
liquidity, maturity and credit risk management (Ghosh et al., September 2012).
b. Costs
Shadow banking can be a major source of systemic risk. As we will discuss in the next section,
the global financial crisis of 2008 originated from the shadow banking sector. There is a growing
recognition that shadow banking system may pose a greater risk than traditional banking. Even

16. 16
though they are exposed to the same financial risks, they don’t have the same level of regulation
and oversight (Ghosh et al., September 2012). The risks include:
Ø The potential for excess leverage: Securities financing transactions (STFs) on a
collateralized basis through repo market – involving commercial banks – and securities
lending transactions to raise more funds in a repetitive cycle through “Rehypothecation”
(Singh and Aitken 2010).
Ø Amplification of procyclicality: shadow banking system interaction amplifies
procyclicality, the mutually reinforcing interactions between the financial and the real sectors
of the economy: upward valuation of collateral assets increasing the credit availability and
SFTs margins being reduced in an upswing, encouraging further the borrowing against the
collateral, leading, in case of a downturn, to the dramatic decrease of assets value.
Ø Instability of wholesale funding and potential for “modern-style bank run”: The shadow
banking system operates through wholesale funding without the assurance of a Central Bank
as “lender of the last resort”. It performs significant maturity and liquidity transformation,
endangering the financial system, making it susceptible to a “bank run”, and other effects.
Ø Transmission of systemic risk: A complex web of interconnections links the shadow
banking activities to the traditional regulated banking sector, where commercial banks form a
part of this chain, supporting and facilitating the shadow banking activities. Subsequently,
the failure of any entity generates contagion affecting the overall system stability.
Ø Regulatory arbitrage: Shadow banking activities may arise from the tighter regulations
imposed on the banking institutions, which pushes the risky activities to the shadows. This
situation jeopardizes the effectiveness of the banking sector regulations, with the risks
becoming greater, particularly if both financial systems are still connected through the
ownership or financial linkages.

17. 17
II. Shadow
banking
and
Global
Financial
Crisis
Shadow-banking system is a channel of dedicated financial institutions that transfer the funds
from the savers to the investors through several methods that are characterized by the secure
funding practices.
The year 2005 was marked by the first time ever that the US banks suffered no loss. 2006
followed and the US realized the same positive result. It looked like the economy was booming,
the real estate sector was on an all time high, assets’ values were skyrocketing, everyone was
profiting, whether it was homebuyers, employees, companies, the government – It was the
“ideal” state to be in.
But, lurking in the shadows was a huge catastrophe waiting to be realized, due to so many factors
from wrong ratings on asset-backed-securities, subprime mortgages, the securitization system,
the desire for profit by the huge investment banks who ignored any negativity in what they were
undergoing, loose regulations on the securitization process, to the unregulated shadow banking
system which helped fasten the process of the crisis…
Shadow Banking played an important role during the credit crisis. The credit crisis started in
2007 and reached its peak in the year 2008. It started with the fall of the Lehman Brothers, a
global financial services bank. Some economists describe it as the worst depression after the
Great Depression of 1930. This crisis affected the investment banking industry, insurance
companies, mortgage lenders and commercial banks throughout the world. In this section, we
will be discussing the shadow banking during the credit crisis.
Shadow Banking had a major role in amplifying and exaggerating the crisis. There are two main
characteristics in the shadow banking system that caused this amplification:

18. 18
Ø The shadow banking system created the Collateralized Debt Obligation (CDOs), which were
the center of the crisis.
Ø The world treated the financial crisis as a continuous process that started in 2007 and
escalated in September 2008. The 9th
of August represents the specific point where it all
failed. The point where the trading of CDOs failed.
The banking system may cause several severe risks as it showed during the financial crisis but in
its essence it was not designed to fail. It is similar to a young boy riding a bicycle. A bicycle is
supposed to be fun and entertaining. Nobody tells the boy when he/she is buying the bicycle that;
if it is driven in an irresponsible manner it might cause death.
Thus we conclude the following, quoting Lysandrou Nesvetailova:” the shadow banking system
is a system of unregulated off bank balance sheet credit intermediation and maturity and liquidity
transformation activities conducted by bank’s owned or sponsored entities in the capital and
money market domains for the primary purpose of expanding the rate of production of yield
bearing debt securities required by the global investor community”. Figure 3 below shows the
outline of the commercial shadow bank at the time of the sub-prime crisis.
Figure 3: Outline of the commercial shadow bank
The securities supplied by the shadow banking system are distinguished into two categories,
short term and long term:

19. 19
Ø Short Term is mainly the asset-backed commercial paper (ABCP). The shadow banking
entities come among the first suppliers of the short term components that include the ABCP.
Ø Long Term is mainly the asset-backed securities and the CDO. The shadow banking entities
came to play an essential role in the pre crisis era through the two above-mentioned factors.
Both the short term and long term securities increase the factors that enable the shadow banking
to be a main driver to the financial crisis. Figure 4 below shows the expansion of the shadow
banking system in the US. It can be observed in the figure that there was an almost steady state
from 1990s till 2000s. A fast increase was observed from year 2000 till 2007. In year 2007 there
was the peek after which it started decreasing.
Figure 4: Growth of Shadow Banking in U.S.A

20. 20
III. Shadow
banking
in
Emerging
Markets
International discussions on “shadow banking” have been almost concentrated exclusively on the
developed countries, ignoring the potential risks in emerging markets. Any global approach on
non-bank financial services should cover and assess the risks no matter where they occur (IIF,
June 2012).
After the global financial crisis, in emerging markets, shadow banking systems continued to
grow rapidly thus accumulating risks. Mark Carney, FSB Chairman and Bank of England
Governor, sees “shadow banking excesses in emerging markets as posing the biggest threat to
the global economy” (Borst, 2014).
The threat is focused around China, being the world’s second economy, having the largest
shadow banking system within the emerging markets. Despite the expressed concern about the
danger lying behind shadow banking, the FSB approach in addressing the problem is quite
ineffective since its methodology is designed for Anglo-American financial systems rather than
for emerging markets. These deficiencies result in a considerable underestimate of the shadow
banking system size in China and cover those who want to prevent regulatory action (Borst,
2014).
There are significant challenges with data availability, size and significance of Shadow banking
in the emerging market and developing economies (EMDEs). Therefore, they are less discussed
and, eventually, less understood. Based on a sample of selected EMDEs in East Africa and in
Central and Eastern Europe, the Shadow banking is relatively small in most of them, but has
grown remarkably during the recent years. (Ghosh et al., September 2012)

21. 21
1. Characteristics
&
Role
in
Emerging
Countries
In EMDEs, shadow banking poses systemic risks, both directly and indirectly. Directly, the
importance of Shadow banking is growing in the total financial system, especially with the
simultaneous credit, market and liquidity risks undertaken by its participants. Indirectly, Shadow
banking is interconnected with the regulated banking system. Concurrently, shadow banks play
also an influential role in channeling alternative funding sources to EMDEs, especially with the
continuous deleveraging pressures from European Banks (Ghosh et al., September 2012).
2. Characteristics
of
Shadow
banking
risks
in
EMDEs
The level of risk posed by the shadow banking system in EMDEs depends on several factors:
Ø The size and systemic important of the sector within the total financial sector
Ø The types of activities performed by the shadow banking sector and their riskiness
Ø The link with the banking sector
Ø Level of regulation
Unfortunately, the characteristics of shadow banks in EMDEs are hard to get and the available
information is fragmented (Ghosh et al., September 2012).
3. Shadow
banking
system
in
Central
and
Eastern
Europe
and
East
Asia
In East Asia, nonbank financial intermediation may provide important shadow banking services
in various regions, despite the dominance of traditional banking in the formal financial sector. It
is the largest in Philippines and Thailand, and its share has been gradually rising as shown in
Figure 5.

22. 22
Figure 5: Evolution of the Shadow Banking sector in selected EMDEs
In Central Eastern European countries, shadow banking grew rapidly until 2007, and lost most of
its share after the global financial crisis. The factors that encouraged the development of
nonbanking institutions in EMDEs are the same ones that stipulated the sector in developed
countries; the tighter regulations on the traditional banking sector made the intermediation more
costly, contributing to the growth of shadow lending in countries like China, Bulgaria, Croatia,
and Romania. Compared to the regulated traditional banking system, these regulatory gaps entail
that as the financial sector grows over time, an important part of it will remain out of the
systemic risk radar and could increase the systemic risks as previously discussed.
China’s shadow banking sector has gained significant attention recently and helps demonstrate
these risks (Ghosh et al., September 2012).
4. Shadow
banking
in
China
The shadow banking in China is defined as lending outside the banking system, without
necessarily involving leverage and maturity transformation. The rapid growth of these lending
activities induced the People’s Bank Of China (PBOC), in early 2011, to the introduction of

23. 23
“Total Social Financing”1
, in order to specifically track loans, entrusted loans and other credit
products intermediated by banks that are not often captured on their balance sheet. Nonetheless,
new products have appeared that prevent the disclosure on this broader metric, in sectors where
the investment yields high returns in exchange of high risk.
Shadow banking in China, occurring through a wide array of entities, is hard to track. Even
though difficult to measure, the Chinese shadow banking size is estimated to have reached
worrying proportions since 2011, and it has grown much due to the tightening control of credit,
and the underground started filling the gap (Ghosh et al., September 2012).
a. China’s
Shadow
Banking
System
components
As defined by Jianjun Li and Sara Hsu, “China’s shadow financial system is comprised of non-
bank financial products, including bank-trust cooperation financial products, products issued by
trust companies and financial leasing companies, and Q-REITS3 and credit risk; and credit
creation products often produced by small loan companies, investment companies, credit
guarantee companies, insurance brokerage firms, pawn shops, private equity investment funds,
and venture capital funds”, but it is dominated by commercial banks (Li & Hsu, August 2013).
The main forms offered by these entities include informal lending and underground
intermediation, entrusted loans, and trust loans2
(Wealth Management Products) and bank
acceptance bills (Barclays Capital 2011; IIF 2012; South China Morning Post 2012).
b. China’s
Shadow
Banking
during
the
Credit
Crisis
China, like any other country was affected by the global crisis. To offset this financial crisis, the
Chinese government encouraged a huge credit boom. Such credits were directed towards
1
China's
"total
social
financing"
(TSF),
a
liquidity
measurement
tool
invented
by
Beijing
in
2011,
to
help
Chinese
leaders
keep
tabs
on
fundraising
as
the
financial
system
diversified
away
from
state-­‐controlled
policy
lending.
The
TSF
is
an
economic
barometer
that
sums
up
total
fundraising
by
Chinese
non-­‐state
entities,
including
individuals
and
non-­‐financial
corporates.
2
Trust
loans
refer
to
credit
extended
through
a
specific
type
of
trust
product
created
jointly
with
banks
and
whose
underlying
assets
consist
solely
of
loans,
which
are
generally
short-­‐term
and
typically
mature
within
a
year.
Trust-­‐loans
are
sold
by
banks
to
their
retail
depositors
or
small
investors
after
securitizing
them
through
a
trust
mechanism.

24. 24
infrastructure and construction projects. Figure 6 below shows the lending amount in billion
Renminbi. It reveals the difference between the actual lending and the target lending. As shown
in year 2009, the actual lending was higher than the target lending by 6000 billion.
Figure 6: Actual lending and target lending
As history has shown us before, after almost every economic boom, we have pause, and then a
quick, sudden economic downturn occurs where we see recessions, banking systems falling
apart, companies that were flourishing going bankrupt… So in China, parties were no longer able
to pay back the loans thus resulting in a contracted economy. As a result, shadow banking,
especially trust securities grew rapidly with insufficient oversight, due to the strict regulation of
the rational banking systems directed by the Chinese government. For the most part, this
represented an attempt to circumvent the interest-rate controls that made bank deposits
unattractive. Savers will turn to shadow banking thus losing some money on those investments,
so now savers will return back to banks. Now the Chinese government is making it clear that
shadow banking will not be bailed out, while the big banks are still obviously supported by the
government.

25. 25
c. Key
concerns
Being outside the state supervision, there is a growing concern that shadow banking threats
China’s financial system’s stability:
Ø Direct linkages with banks: mainly through the issued letters of credit and their role in
entrusted loans and use of off-balance sheet Wealth Management Products (WMPs)3
to
attract deposits.
Ø Indirect linkages with banks: Isolated defaults have the potential to initiate widespread
redemptions, knowing that these defaults shall not be added directly to commercial banks
Non-Performing Loans (NPLs).
Ø Exposure to market, credit, and maturity/liquidity risk by trust companies: the main
risks seen with trust companies are their dependence on the assets prices, being subject to
potential correction and frequently risky pricing behavior for the sake of attracting
investments. This entails that any economy slowdown accompanied or not with a decline in
asset prices will trigger an increase in defaults.
This rapid growth of the underground lending and the related high borrowing rates increases the
emergence of potential social and political tensions. Shadow banking raises the concern of
weakening macroeconomic management making monetary policy ineffective (Ghosh et al.,
September 2012).
d. Measures
taken
by
Chinese
Authorities:
Chinese authorities have undertaken some measures to address the risks posed by growing
underground banking activities:
Ø Monitoring and indirect regulation:
3
Wealth
Management
Products
(WMPs)
are
short-­‐term
products
to
savers
that
pay
high
interest
rates
but
allow
the
banks
to
bring
the
deposits
back
on
their
balance
sheets
at
the
end
of
each
month
to
meet
their
regulatory
requirements

26. 26
o Establish a monitoring system for private lending.
o Banks are required to include, in their reserve requirement ratios, letters of credit and
bank acceptance bills.
o Preserve legitimacy of private lending for small and medium-sized enterprises (SMEs)
Ø Shadow banking related to bank-trust cooperation measures cover:
o Bank-Trust loans are to be limited to less than 30% of total bank-trust business.
o Banks are required to move back off-balance sheet trust cooperation by end of 2011
o Large banks should set aside risk-weighted capital of 11.5% for trust loans off-balance
sheet, and small banks set aside 10.5%
o Trust companies should set aside risk-weighted capital of 10.5% of capital for trust loans
that are off-balance sheet
o Trust companies are prohibited from distributing dividends unless the compensation
reserve is less than 150% of their NPLs or less than 2.5% of the trust loans extended in
the bank trust cooperation (Barclays Capital, 2011)
o Shadow banks are formalized through an experimental financial reform zone in
Wenzhou during March 2012, in an attempt to convert underground small loans
companies to local banks serving SMEs.
These measures are important in addressing the growing size of the Chinese underground
banking sector. Given the direct and indirect linkages to banks, monitoring and regulating this
sector and formalizing shadow lenders, should contribute to the reduction of these risks.
However, this rapid growth of this sector is a response to tight regulations on the deposits and
lending rates, directing borrowers to alternative means to access funds and for lenders alternative
higher returns on their savings. The effective and lasting solutions for this problem lie in
addressing the root causes of the problem (Ghosh et al., September 2012).

27. 27
IV. Regulatory
Reform
As we have seen in the report, the shadow banking sector led to severe negative consequences on
the global economy, like the subprime crisis of 2008, the European sovereign debt crisis and so
on. For these dangerous reasons, where economies are prone to collapse, countries to sink into
more debt, some solutions must be taken into consideration in order to enhance economic growth
and prevent or reduce this systemic crisis, which leads to “chaos” in the global financial markets.
During the aftermath of the fall of Lehman Brothers, and the new awareness regarding the
inefficiencies of all types of institutions and governments, and specifically the role that the
shadow banks played during that period, it is obvious that the regulations of the financial sector
along with risk-management were not able to capture the risks the banks were exposed to,
specifically, market liquidity. So many other weaknesses were also observed: lack of adequate
risk management systems, or lack of governance practices, ineffective supervision, etc.
This section discusses briefly the objective of the regulation of these financial institutions and the
necessary reforms to be adopted in order to promote a less leveraged, less risky, and thus a more
resilient financial system that supports strong and sustainable economic growth.
An important factor to take into consideration is that by regulating the financial systems, the
objective is not to cripple the growth and sustainability of the economy as a whole – in our case,
the intermediation of liquidity, which increases the money supply and boosts economies in
general.
G-20 Summit (April 2009)
In order to strengthen the financial system and increase the confidence of the people, the G-20
group of countries approved on a set of reforms.

28. 28
The Basel Committee on Banking Supervision (BCBS) came up with guidelines at the end of
2009 for banks to improve their loan requirements and to tighten the grip more on the business of
loans and liquidity management. Later in 2010, some of these guidelines were accepted and
agreed upon.
Before we discuss the main components that the BCBS proposed, it is important to know how
the shadow bank’s liabilities were picking up and ultimately outpacing the commercial bank’s
liabilities from the year 1990 till 2012, as shown in figure 7 below.
Figure 7: The trend of shadow bank liabilities vs. bank liabilities from 1990 to 2011 (Federal Reserve Bank of New York
Stuff Report- February 2012)
In short, it is clear to say that liabilities of shadow banking are much higher than that of
traditional banks, which may result in a higher risk of default on interest payments due to the

29. 29
wide gap between deposits and loans, in other words, shadow banks bear higher risks than other
institutions.
BCBS Proposals
The main elements of the BCBS propositions are:
Ø Improving the quality of raising capital (Increasing the use of common equity to raise funds
and decreasing the amount of fixed-income securities).
Ø Enhanced risk identification for market and counterpart risk.
Ø A non-risk based leverage ratio as a backstop measure.
Ø Tighter liquidity criteria, specifically to control the gaps created by lending long and
borrowing or getting deposits for the short-term.
Ø Capital conservation buffers: From 1988 till today, we have had three accords, which are
Basel I, Basel II, and Basel III. In summary, Basel I focused on capital requirements for
banks. Basel II dealt with new rules on capital requirements, and created new regulations and
standards on how much capital financial institution must reserve and maintain (non-interest
earning reserves). Banks needed and were obliged to follow those guidelines and put aside
capital to decrease as much as possible the risks associated with its investing, but more
specifically, lending practices. Basel III (which its main elements were explained above) is
an extension of Basel II, with improvement in the banking sector’s ability to deal with
financial and economic downturns, to improve the risk management of the financial
institutions and strengthen as much as possible the transparency of banks and their activities.
For example, a very important requirement was put in effect, whereby requiring from every
international bank in the world, to create a “Financial Risk Management” (FRM) department
if it doesn’t have one already. New Basel III percentages were lately set for common equity, tier 1

30. 30
capital and conservation ratio. The Appendix at the end of the report illustrates the effect of the
reserve requirement regulation.
Figure 8 demonstrates that there is a considerable increase in the tier 1 capital and the
conservation ratio up to 2020, and the increase is gradual over time.
Figure 8: Basel III common equity and tier 1 capital changes
Currently, financial regulations combine two distinctive actions:
Ø Monitoring individual institutions and their impact on system stability.
Ø Investor regulation and consumer protection
The second action highlights the fact that the Security and Exchange Commission (SEC) is a
regulator that specializes in regulating the listed companies. Investors and consumers should
abide these rules. However, to cope with systemic crisis, such regulators are in need of more
systemic information to gather and analyze. To be more accurate about the information that
should be gathered, it must be reported from a wider range of financial institutions, such as
hedge funds and the shadow banking system. In addition to this, the systemic regulator will
operate capital rules with a systemic focus.

31. 31
It’s important to mention that in times of crisis, it’s the role of the central bank to interfere and
play its role in the resolution of problems occurring due to systemic crisis and improving the
economic cycle.

32. 32
Conclusion
Non-bank credit intermediation institutions have a valuable role in the financial systems, from
which all can benefit: investors, borrowers, banks, and the wider economy, while being
complementary to the traditional banking system. Regulated banks, non-rivals in this business,
may rely on these activities to provide services. Non-bank institutions can take many forms and
can perform a large set of activities that hold a large degree of risks to the global financial system
if not closely supervised and regulated.
Markets are constantly evolving and financial market innovations will always exist and these
shadow banks will always find a way to go on with their activities. This places an obligation on
the regulatory authorities to establish a control system that compromises between keeping the
benefits of the shadow banking system and avoiding the excessive risks, and the difficulty in the
regulations that need to take into consideration loopholes in the system that are being used day
by day, by corporations, banks and so on....
Shadow banking sector, with its intermediation tools and varied instruments, is complicated, thus
difficult to estimate and to regulate. The greatest risks lie in the association of shadow banking
activities with traditional banking sector activities. This puts the banking sector under the
pressure of a constant systemic risk, decreasing the confidence in the people, and making the
global economy more susceptible to crisis that are unseen. It is proved by the global financial
crisis, in which the whole financial system collapsed, that unless shadow banking activities are
properly managed, shadow banks will pose great systemic risks. These risks should be
monitored, assessed, and mitigated on a continuous and adaptive basis. The risk remains viable
in the emerging markets, where poor regulations and the growing size of this shadowy sector

33. 33
coincide, especially in China. As its name expresses, shadow banking, even if it is much
discussed, analyzed and explained, will always have a dark side that’s hard to depict and to
control. Will financial systems integrate it one day and keep it regulated and transparent like the
regulated banks? That, we will never know, at least for now.
References
Ø Adrian, Tobias & Ashcraft Adam B.: Shadow Banking: a review of literature, Federal
Reserve Bank of New York, Staff report No. 580, October 2012. Retrieved from:
http://memofin.fr/uploads/library/pdf/sr580[1].pdf
Ø Claessens, Stijn and Ratnovski, Lev: What is Shadow Banking? IMF Working Paper
Research Department, February 2014. Retrieved from:
http://www.imf.org/external/pubs/ft/wp/2014/wp1425.pdf
Ø Claessens Stijn, Pozsar Zoltan, Ratnovski Lev, and Singh Manmohan: Shadow Banking:
Economics and Policy, IMF Staff Discussion Note SDN/12/12, December 4, 2012. Retrieved
from: http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf
Ø Borst, Nicholas: Flying Blind, The Magazine of International Economics, Winter 2014.
Retrieved from: http://www.international-economy.com/TIE_W14_Borst.pdf
Ø Ghosh, Swati, Del Mazo, Ines Gonzalez, and Ötker-Robe, İnci: Chasing the Shadows: How
Significant Is Shadow Banking in Emerging Markets? Economic Premise, Poverty Reduction
and Economic Management Network (PREM), The World Bank, Issue 88, September 2012.
Retrieved from: http://siteresources.worldbank.org/EXTPREMNET/Resources/EP88.pdf
Ø Kodres, Laura E.: What Is Shadow Banking? - Back to Basics - Finance & Development, June 2013.
Retrieved from: https://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm

34. 34
Ø Li, Jianju and Hsu, Sara: Shadow Banking in China: Institutional Risks, Working Paper
Series Number 334, Political Economy Research Institute, University of Massachussets
Amherst, August 2013. Retrieved from:
http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_301-
350/WP334.pdf
Ø Recovery Strengthens, Remain Uneven, World Economic Outlook International Monetary
Fund, World Economic and Financial Surveys, April 2014. Retrieved from:
http://www.imf.org/external/pubs/ft/weo/2014/01/pdf/text.pdf
Ø Shadow banking: a forward-looking framework for effective policy, Institute of International
Finance, June 2012. Retrieved from: http://www.iif.com/download.php?id=aYFmUgfMDbA
Ø Pozsar, Zoltan & Singh, Manmohan: The Nonbank-Bank Nexus and the Shadow Banking
System, IMF Working Paper WP/11/289, Research Department, December 2011. Retrieved
from: http://www.imf.org/external/pubs/ft/wp/2011/wp11289.pdf
Ø Singh, Anoop and Kochhar, Kalpana: People’s Republic of China, International Monetary Fund
Country report No. 13/211, Staff Report for the 2013 Article IV Consultation, July 2013. Retrieved
from: http://www.imf.org/external/pubs/ft/scr/2013/cr13211.pdf
Ø Crash course, the Origins The origins of the financial crisis, The Economist, September 7,
2013 (from the printed version). Retrieved from:
http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-
being-felt-five-years-article
Appendix:
Depositing
and
Lending
Cycle

35. 35