FSB: Game of ‘Shadows’

Siddhidatri Mishra from the Financial Times talks about the risky game of shadow banking.

The eruption of the financial crisis in 2007 had adverse effects on the World Economy. While prominent banks were filing for bankruptcy, investigations were carried out to find out the root cause of the crisis. Financial analysts soon came to the conclusion that shadow banking had significantly contributed to the setback and realised just how dangerous this pseudo sector could be.

Poet Robert Frost once said that banks were places which would provide one with an umbrella in fair weather and take it back when is started to rain. Banks have become a formidable entity of sorts to the common man; the lengthy procedures one has to follow, low interest rates, low level of risk taking while investing made people and institutions look for alternatives – and thus shadow banking emerged.

Shadow banking has been defined as the system of credit intermediation that involves entities and activities ‘outside’ the regular banking system. It is a broad term which includes financial institutions that perform activities similar to the traditional banking system but ‘without’ the regulations. Examples of these institutions include hedge funds, investment banks and mortgage brokers. The investor is assured that he/she will be able to earn a much more higher profit in a shorter period of time as compared to banks.

However, every coin has its flip side. While shadow banking seems to be lucrative on the surface, it comes with its associated risks. This system of banking is more likely to lead to financial instability as shadow banking is neither subject to regulations, nor eligible for emergency facilities designed by the Government to assuage financial inconsistencies in the economy. Additionally, the banking activities are spread across borders and geographical jurisdictions thus making it impossible to curb these activities. The steps carried out during the process are not as transparent as those of a bank and even a modest shock to the system can set off a chain of unpropitious events.

The Financial Stability Board is an organising body that unites the financial decision makers of member Nations and territorial bodies, such as the European Central Bank, to come up with policies that fortify monetary soundness. It falls upon this body to suggest methods to regulate the system of shadow banking and ensure its integration into the regular system of banking.

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