How shadow banking works

ON JANUARY 5th, in a campaign speech in New York, American senator Bernie Sanders pledged to break up banks that were deemed "too big to fail" and vowed to put a leash on their shadowy cousins. Janet Yellen, Federal Reserve's chair, has admitted that shadow banks pose "a huge challenge" to the world economy. In an editorial for the New York Timesin December, Hillary Clinton called for tough measures to contain the global bogeyman. Politicians and economists who often have little in common, unanimously agree that shadow banking, left to its own devices, has the potential to trigger another financial collapse. What are shadow banks and why is there such a fuss about them them?

The term "shadow bank" was coined in 2007 by Paul McCulley of PIMCO, a big bond fund to describe risky off-balance-sheet vehicles hatched by banks to sell loans repackaged as bonds. Today, the term is used more loosely to cover all financial intermediaries that perform bank-like activity but are not regulated as one. These include mobile payment systems, pawnshops, peer-to-peer lending websites, hedge funds and bond-trading platforms set up by technology firms. Among the biggest are asset management companies. In 2013 investment funds that make such loans raised a whopping $97 billion worldwide. Companies looking for cash also lean on bond markets that offer extraordinarily low interest rates. Globally, between 2007 and 2012, firms thus raised $1.7 trillion by issuing corporate bonds. Money-market funds that invest in short term securities like US treasury bills have taken off too. In China alone, they grew six times to 2.2 trillion yuan ($341 billion) between mid-2013 and December 2015. In December they hit a sweet spot when Federal Reserve hiked interest rates for the first time in nearly ten years. The Financial Stability Board, an international watchdog estimates that globally, the informal lending sector serviced assets worth $80 trillion in 2014 up from $26 trillion more than a decade earlier.

Shadow banks have flourished in part because the traditional ones, battered by losses incurred during the financial slump, are under pressure. Tighter capital requirements and fear of heavy penalties have kept them grounded. In China, where banks are discouraged from lending to certain industries and are mandated to offer frustratingly low interest rates on deposits, non-banks fill the gap. About two-thirds of all lending in the country by shadow banks are in fact "bank loans in disguise", reckons the Brookings institution, a think tank. Critics worry that unlike banks, which lend against deposits from customers, non-banks loan money using investor's cash and rotating lines of credit. This is especially risky when skittish investors who bet on short term gains withdraw their money at once. But non-bank financing need not always be a bad thing. It offers an additional source of credit to individuals and businesses in countries where formal banking is either expensive or absent. It also takes some burden off banks which have big "maturity mismatches" (the difference between the amount of time a depositor's money is parked in the bank minus the time that it is loaned out). And belatedly, regulators, too, are waking up to the new financial order. Banks must now declare structured investment vehicles on their balance sheets. Authorities have considered imposing leverage limits on various forms of shadow banks in America and Europe. In January last year, America's Federal Housing Finance Agency proposed new rules that would require all non-banks to have a minimum net worth of $2.5m plus a quarter percentage point of the outstanding loan stock that they service. Only then would they be able to sell their loans to Fannie Mae and Freddie Mac, which buy American mortgages from banks, bundle them into securities and resell them to investors with a guarantee. The move aims to protect the two government-backed housing giants against under-capitalised lenders. It is a small start to rein in an industry that accounts for a quarter of the global financial system.