Shadow Banking & its investment perspective

Shadow Banking & its investment perspective

Shadow banking refers to credit intermediation being conducted outside the regular banking system. This article focuses on the scope of shadow banking along with its evolution in India. Shadow banking has alternative channels of funds that include a variety of non-bank loan companies, microfinance companies specializing in credit provision to small companies, peer-to-peer lending, and various forms of retail-oriented loan provision. The main purpose of this article is to consider the development of shadow banking policy initiatives from the perspectives of investors and how it has worked its way as a valuable source of non-bank finance that has supported real economic activity.

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Over the years, there has been an immense growth in the non-deposit taking non-bank financial corporations which have proven to be important to the country’s development. The article majorly covers the growth trend of NBFCs in a country like India amongst other emerging countries. Some of the analysis has been done using case studies about recent conundrum caused by unregulated lending in name of shadow banking and further highlight its effects on the economy as a whole. Furthermore, the report will evaluate the investor sentiments based on the prior knowledge of the fact that shadow banking institutions lack transparency, and the inadequacy of data on such activities makes the economic analysis costly and prohibitive. 

Growth of Indian Non-Banking Financial Institutions

When considering growing economies like India, there is not only the presence of formal sources of credit and other banking services but also the availability of quasi-formal and informal networks of trade financiers, Gold Saving companies, Gold loan companies, etc. that have been adding to the financial growth of the country.

The non-banking lending institutions have existed in India since before independence, but it was in 1963 when RBI introduced a regulatory act stating measures to supervise, regulate and control their functioning in the country. Since then, NBFCs have been operating in the country providing better credit facilities to those who cannot afford the more formal credit opportunities available. In 1998, RBI changed the regulations and supervisory structure for the NBFCs wherein they tried focusing on the three major categories:

  • Deposit-taking NBFCs
  • Non-Deposit taking NBFCs
  • Core investment companies

This division of categories ensured that the NBFCs were protecting the interest of depositors. But even after a clear division of these categories and lenient regulations, the number of NBFCs and investments in NBFCs started falling gradually. The evidence of the same can be seen in the table below that shows a fall in the number of deposits in NBFCs from the year 2006 to 2011.

200620102011
Number of deposits taking NBFCs428308297
Bank deposits of all banks (trillions of rupees)21.85846.35253.552
NBFC public deposits as percentage of bank deposits1.05%0.37%0.22%
Comparison of Bank and Deposit Taking NBFC Deposits. This table compares the deposit taking NBFC deposits to the bank deposits for the fiscal years 2006, 2010 and 2011. Source: Finance Ministry of Government of India
shadow banking

Soon after 2011, RBI again changed the guidelines for these institutions in 2013, thereby majorly combining them into two broad categories of Investment companies and Financing companies. Amongst these changes, one of the most important changes was the one introduced in 2006 wherein the NBFC

supervisory framework introduced capital adequacy requirements. These capital adequacy requirements were stringent and hence these made Indian NBFCs to appear more tightly regulated as compared to shadow banks in other parts of the world. Also, considering the investment perspective, investors borrow heavily from both shadow banks and conventional banks as both the systems are potentially intertwined.

Global Structure of Shadow Banking: A case study of Mozambique and Cambodia

Apart from the Indian reference many other countries like Cambodia, Mozambique, Costa Rice, Malaysia, and Tajikistan also constitute traces of shadow banking, but, in distinguished institutes. Sources and factors affecting the degree of shadow banking may differ in various states however the gest of riskiness to the financial integrity of these economies can be drawn on similar lines. 

Mozambique

Shadow banking in this state falls into two categories – formal and underground entities.

Formal Entities: The parties under this segment that provide loans are the Money Lenders and Savings and Loans Organizations. Banco de Mozambique (Central Bank) does not keep a sagacious regulation on these formal entities. As a result, many of the operators report a few data items like the total loan amount, no of beneficiaries involved, and charges upon the

loans i.e., the interest rate once in their semester period. Withstanding this, many of these entities do not even provide this information and, the submitted data lacks accuracy and hence is invalid.

Underground Entities: These entities have the characteristics of an informal lender that lends without any mortgage or credit ratings of the borrowers. Information on the assets of these entities is generally scarce due to their informal nature of operations. However, the point to focus on here that it is believed is that the assets of this sector are quite large and sizable in comparison to the other formal sector.

Cambodia

Similar trends can be witnessed for this state in terms of the presence of shadow banking. Nevertheless, one imperative reason that is specific to the growth of shadow banking activities in Cambodia is the regulatory arbitrage wherein, the increased regulation in the formal sector creates an ulterior incentive to undertake the shadow banking approach.

The key factors that nudge its occurrence are the following:

  • Lenders can opt for an alternate source of funding and channelizing their funds outside the purview of the Central Bank. Therefore, they select a way that involves fewer regulations as a response to too tight and strict policies in the lending sector.
  • Some of the lenders can also find a way to channelize their funds through Non- Government Organizations (NGOs) in the form of social charities. So, borrowers of the form of NGOs can get hands-on funds without any restrictions and regulations.
  • Small and micro-level borrowers find it difficult to approach sources that are highly regulated and standardized as they do not possess any previous record of credit rating and character certificates. Thus, it creates a niche market for shadow banking lenders.

Risk Posed by Shadow Banking

After considering the presence of different degrees of shadow banking there needs to be consideration of the plausible riskiness of these types of banking systems to the financial institutes. Many of the global financial crisis that took place are either due to the weak macroeconomic pillar of the economy or due to the domestic credit constraints and huge dependence on another alternative mode of financing that is less regulated. This consequently ensures that an increase in the shadow bank financing and huge dependence on it in an economy could pave a way for another financial crisis. 

Shadow banking affects the supply chain of funds and therefore determines the liquidity in an economy that shapes the structure of a systematic risk either due to its potential nature in supplying credit or its interconnectivity with the regulated banking system. These links can take several forms. A direct link could channel the deposit into the shadow banking system instead of the official banking segmented therefore resulting in inefficient allocation of deposits and a source of counterparty risk exposure to the banks. These risk exposures arise from banks’ lending or by holdings of debt securities issued by the shadow banks. The indirect link usually means the exposure of common assets holding. Also, at the time of financial distress, shadow bankers can dispose of the common assets holding impacting the market sentiment and creating a situation of change in expectations in the economy. Lastly, the lack of registered data and knowledge of shadow bang also poses another systematic risk to financial stability.

Conclusion

The global financial front has always had an overachieving goal of having a strong financial structure that reforms the lack of availability of credit and enhances the investment perspective of the investors worldwide. This system involves handling the complicated relationship between banking and non-banking financial institutions that help take up all the opportunities available for securitization and lending. Considering all the shreds of evidence from the literature above and the case studies used in the explanation, the article well establishes the fact that even after the risk factor attached to shadow banking, it can be a great option for extending the investment opportunities and this sector will be an option that complements the global formal banking structure.

Ms. Aaroohi Dudeja
Ms. Aaroohi Dudeja

Ms. Dudeja is a data scientist by profession. An Indian Institute of Foreign Trade (Delhi) alumna.

Ms. Meghana Gandhi
Ms. Meghana Gandhi

Ms. Gandhi is an economist by profession. An Indian Institute of Foreign Trade (Delhi) alumna.

This chapter was submitted to ECONOMIKA 2021 dated 16th February 2021. All rights reserved. No part of this publication can be reproduced or transmitted in any form or by any means, electronic, or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from Ecofunomics LLP.

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