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Exploring the need for clear distinction between shadow banking and market-based finance, for better financial stability and risk management.
The terminology ‘shadow banking’ has evolved significantly since being coined in 2007. Initially, it was used to describe activities that were akin to banking but operated outside the regulated banking perimeter. Over time, it has become a catch-all phrase for non-bank finance, causing misrepresentation of the associated risks. This paper aims to draw a distinction between shadow banking and market-based finance, delineating their differences and implications for the financial system.
Shadow banking, a term attributed to activities that mirror banking but evade its regulatory scope, has gradually broadened to encapsulate all non-banking finance. This blanket use obscures the true risks associated with the vast majority of non-bank finance, which contributes to financial stability rather than threatening it.
This paper proposes a clear distinction between shadow banking and market-based finance. Shadow banking should refer strictly to entities that have substantial asset-liability mismatches and potential access to official sector backstops, placing taxpayers at risk. Meanwhile, market-based finance should encompass capital invested in the real economy, either directly or through pooled vehicles.
The current practice of lumping many different activities under ‘shadow banking’ hampers policy makers’ abilities to fully monitor and address financial stability risks. To this end, we recommend amending the existing regulatory definitions of shadow banking to account for how activities and entities are funded. Investment funds and asset managers should be exempt from measures of shadow banking.
Given the technical nature of this paper, there are no specific code examples. However, the process of distinguishing shadow banking from market-based finance involves rigorous data analysis and policy interpretation, requiring a certain degree of technical expertise.
By separating shadow banking from market-based finance, regulators can better monitor and mitigate risk in the financial system. Inconsistencies in data produced by entities like the Financial Stability Board could be avoided, creating a more accurate picture of financial stability risks.
Without a clear differentiation between shadow and market-based finance, there is a potential burden on taxpayers through access to official sector backstops. Avoiding such scenarios is a key part of maintaining financial security.
If inconsistencies in shadow banking data persist, regulators may need to reevaluate their definitions or consider other aspects of the financial system that are not currently being accounted for.
In a time when policy makers are reviewing post-crisis regulatory reforms, distinguishing shadow banking from market-based finance is crucial. By doing so, we can shed light on the true nature and risks of non-bank finance, contributing to a more stable financial system.
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