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What Is a Shadow Banking System?

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  • Written By: K. Kinsella
  • Edited By: Shereen Skola
  • Last Modified Date: 05 September 2016
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A shadow banking system consists of organizations that offer the same kind of credit facilities and financial services as banks. Unlike commercial banks, the entities within a shadow banking system are largely unregulated and in most instances, these organizations do not have access to government funds or credit facilities provided by government operated central banks. Many businesses and private investors turn to the shadow banking system when conventional banks impose tight underwriting guidelines.

Money market mutual funds are one type of financial company that operates within the shadow banking system. Like other mutual funds, money market funds contain a portfolio of different investment vehicles and these assets are controlled by a fund manager. Typically, these funds invest in short-term debt securities many of which are issued by publicly listed or private corporations. These entities pay interest to the fund and the interest payments are passed onto shareholders in the form of dividend payments. Many large companies primarily borrow money through selling debt securities to mutual funds rather than obtaining conventional loans from banks.

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Start-up businesses and individuals with poor credit are often unable to borrow money from commercial banks. These borrowers often turn to the shadow system because investors within this market are willing to assume higher degrees of risks than banks. Many investment companies specialize in issuing loans to high-risk borrowers, then bundling thousands of loans together to create investment funds. Speculators and other investors then buy bonds that are secured by these pools of investments. Investors mitigate the risks by demanding higher interest rates than banks while borrowers within the shadow market willingly pay these rates due to the lack of more affordable options.

In some countries, government-sponsored entities take an active role in the shadow banking system. Typically, these entities attempt to stimulate the housing market by converting pools of government-insured mortgages into marketable securities. Investors can often generate higher levels of return by investing in these debt securities rather than depositing funds in traditional bank products.

Securities regulators in many countries are responsible for ensuring that mutual funds and other entities within the shadow banking system disclose critical information to investors, such as the types of instruments that are held within a particular fund. Despite these disclosures, regulators are not responsible for protecting the principal that investors use to buy the securities. Conversely, banking regulators in many countries must ensure that banks always have sufficient funds on hands to cover outstanding liabilities. Therefore, borrowers and investors within a shadow system are exposed to greater levels of risk than conventional bank clients.

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