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SHADOW BANKING – ENCROACHING THE TRADITIONAL BANKING SYSTEM?

Author: Deepansh Jain, IV year of B.A.,LL.B.(Hons.) from Symbiosis Law School, Pune


Abstract

Shadow banking in India has attracted attention over the last 30 years, after financial deregulation in the early 1990s which led to the emergence of Non-Banking Financial Companies (hereinafter referred to as “NBFCs”). During this time, NBFCs have gained market share, frequently at the expense of the public-sector banking system. The article talks about how the shadow banking system have come under a regulatory focus and how it was one of the major causes of the financial crisis that happened in 2008. However, commercial banks remain one of the sector's most important funding sources. In recent years, a severe crisis has raised concerns about shadow banking's threats to India's financial system. The article also talks about how the traditional banks have an upper hand over the shadow banking system and what are the prime issues that are faced by this sector.


Introduction

The world got off from a horrible financial crisis in 2008 and the financial sector became more anxious of the significance and multitude of risks posed by the Non-banking Financial Sector. Initially this sector was neglected and ignored completely but now it has recently got attention after some regulations post crisis appeared.


In countries like India this system plays a pivotal role in financial inclusion and in conduct of credit functions. However, shadow banking is exceedingly risky due to the fact that it operates differently than the regulated banking system and engages in less transparent and less regulated financial transactions than traditional banking. It contributes to the expansion of the financial sector but, it brings with it certain risks that need to be taken into account.


What do you mean by‘Shadow Banks’?

The term was coined by the Paul McCulley (An Economist) in 2007 in which he compared it with the traditional commercial banks and said that Shadow banks do something similar.


He urged that these non-banking financial institutions raise (mostly borrow) short term funds and use them to buy long term maturities. Multiple definitions have emerged since then. However, simply understood, Shadow banks are institutions independent from the core traditional system and are non-banks that perform bank like functions outside the regular banking system. These institutions function as intermediaries and generate liquidity in the entire financial system.[1]


Why do banks have an upper hand to NBFCs?

The traditional financial institutions’ critical role is to give credit through maturity transformation which is done with the acceptance of short-term liabilitiesand converting them into these long-term assets like loans and other things like advances. However, this function creates the risk of liquidity.[2]


Moreover, banks operate with significantly more debt than non-financial companies, which may enhance their risk.As a result, banks are subject to a complex and strict regulatory framework. So, when non-bank financial firms, which are neither regulated nor subject to strong scrutiny, undertake bank-like functions, considerable system-destabilizing risks are created.


Why banks have an advantage over these NBFCs is mostly due to the liquidity crunch that the whole NBFC sector faces. Alternatively, compared to NBFCs, banks are more reliable and offer more competitive interest rates. In addition, disadvantages such as high processing costs, slow documentation processing, the absence of an overdraft facility, and expensive deposits indicate that the traditional banking system retains its worth.


Issues faced by the shadow banking sector

Some of the problems that are faced by this sector are-

  • The process of transparency is quite murky, and its entities are characterised by a lack of information regarding the value of their assets.

  • Little or no regulatory oversight on the entire system as compared to traditional banking paradigm.

  • Liquidity issues and no support to help prevent the fire sales (sale of assets in order to repay the investors if they become skittish about the long-term holdings)

The main menace started in 2018 when a string of defaults was done by a Fortune 500 company and India’s largest NBFC at that time, IL&FS and with IL&FS defaulting and creating a contagion effect on other companies fearing that the fall of IL&FS might spread throughout the financial sector, and large institutional owners refusing to provide cash infusions, the government was obliged to assume control of the company.


But after this the Indian financial system got introduced to the high risks[3] that shadow banking can bring about and how it can turn into something ‘dark’ when coupled with fraud, and bad corporate governance.


Regulation of The Shadow Banking Sector

It is under the ambit of RBI, under which the regulation of NBFCs take place, but because of the involvement of Mutual funds in this scenario, Securities and Exchange Board of India(SEBI), which lays down rules for Mutual funds also has an upper hand for the regulation of the sector.


In the latest ruling by the RBI, the body has maximised the exposure in which a bank can have to a single NBFC from 15 percentto 20 percent of its Tier-1 capital.


According to one of India's prominent bankers, the crisis was handled deftly through the asset sale and the authoritative control over IL&FS, preventing it from becoming the next Lehman moment in India.


Regulation of NBFCs was deemed vital for three reasons: ensuring the efficacy of credit and monetary policy, protecting the interests of depositors, and ensuring their healthy growth (NBFIs).


Additionally, SEBI regulated the maintenance of liquid assets, primarily cash and government securities,in order to reduce sectoral exposure and increase diversification. Although significant lessons have been learned from the financial crisis, tight regulation and acknowledgment of the shadow banking system are necessary.


The central bank announced in December 2021 that it will implement risk-based internal audits at large NBFCs and closely monitor 100 of the country's largest NBFCs to safeguard financial stability. It has also recommended a four-tiered regulatory system for NBFCs that targets their capital levels, lending, and governance standards in an effort to prevent future failures. The new regulatory structure would comprise a "base layer, middle layer, upper layer, and a possibly top layer," with no NBFCs falling under the top layer unless the perceived level of risk reaches to an acute level. NBFC entry standards might be tightened by increasing the minimum net-owned-funds level by a factor of 10, with the RBI also recommending the alignment of bad-asset detection between banks and NBFCs by reducing the categorization period from 180 to 90 days. It is difficult to conclude that how things are looking for this sector in 2022 and the way forward, but despite the RBI lowering the rates last year, the loan growth fell to a new two year low in February 2022.


The report also highlighted that NBFCs and other housing finance firms are the largest borrowers right now and for which a substantial portion of the funding and the money is coming from the traditional set-ups – banks. As a result, the failure of any shadow lender could have a significant impact on their banks' viability.


Conclusion

While NBFC regulation is strengthening, the financial sector is becoming increasingly vulnerable from inside – particularly with regard to corporate governance issues – and externally – in terms of the deteriorating macroeconomic scenario. Despite its systemic risks, shadow banks are widely recognised as a crucial financial institution.


RBI has been working constantly to work on the regulation of shadow banks and secure the general public’s interest. The growing size of this sector is a thing to worry about and a lot needs to be done in order to prevent a situation like dewan or IL&FS.


The reports also indicate that shadow banking in developing countries may differ significantly from that in developed economies in terms of being well equipped with capital, potentially plugging holes in inadequate or incomplete intermediation, and being influenced by the flight of reserves to state-owned banks in times of crisis.


Hence it is difficult to give a definitive answer as to whether the growth of shadow banking is good or bad and whether it will hamper the traditional banking system in the coming years. There are factors and indicators that do talk about the risks that are building up at least in some particular areas.


[1]What Is Shadow Banking?’, IMF Working Paper, WP/14/25, February. [2]Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets?’, Economic Premise, World Bank, Number 88, September. [3]R. Gandhi, ‘Danger Posed by Shadow Banking Systems to the Global Financial System-The Indian Case’, RBI Monthly Bulletin, September, 2014.