The state of the global shadow banking system – Are there ways to regulate such activities?

According to a Bloomberg News report dated January 27, 2014, published estimates indicated that the size of the global shadow banking system amounted to approximately USD 70.0 trillion, and the US-based Financial Stability Board has come out to say that it poses “systemic risks” to the global financial system. The main drivers of the growth in shadow banking system come from two leading Asian nations, including China, and India, with China topping the most in size as measured in dollar terms, which according to some estimates, amounted to approximately USD 6.0 trillion.

The global shadow banking system is sometimes being misunderstood as financial transactions that are conducted solely through underground means, and is being used entirely to fund illegal activities such as drug trafficking, money laundering, illegal loan sharks, among others. However, other legitimate forms of financial activities including derivatives trading, foreign currency trading, swaps which are conducted mostly over-the-counter are also being included as part of the entire global shadow banking system. However, a global regulatory system that is consistent and applicable in most countries remains a far-fetched, distant hope that can be accomplished anytime soon due to the circumstances that is unique to individual countries, and international regulations might be perceived as interference into their respective sovereignty boundaries.

A chart illustrating the growth in global shadow banking assets is as follows:

Picture of a chart from Bloomberg showing the growth in Shadow Banking System - Feb 14 2014

Source: Bloomberg.com. Financial Stability Board

The growth trajectory as illustrated in the graph does point to somewhat of a global concern that if the shadow banking system is not being monitored closely, it could turn out to be a so-called ‘déjà vu’ like phenomenon equivalent to the sub-prime debacles that nearly brought down the entire global financial system back in the fall of 2008. However, as mentioned in the preceding paragraph, there hasn’t been any introduction of a consistent set of rules and regulations that can be applied across in all countries.

China continues to take the lead in terms of size and volume of transactions being conducted through the shadow banking system with the introduction of several wealth management products being marketed through many state-owned banking trusts and non-financial services firms. The Chinese regulators have so far not been able to keep up with the rapid expansion in shadow banking system, and was nearly been dragged into the spotlight during last month’s bailout of China Credit Trust, which was supposed to be one of the off-balance sheet vehicles operated by state-owned Industrial and Commercial Banking Corporation (ICBC), and was thrown into the spotlight as it was facing severe funding shortages leading up to its mandatory payment date for trust holders at the end of January. The ICBC decided to change its previous stance, and managed to compromise by allowing investors of the China Credit Trust wealth management product to redeem their full principal without any loss of capital.

China has tried to regulate the shadow banking system, including the June 2013 cash crunch episode, which led to Chinese money markets soaring to as much as 14.0 percent overnight, before restoring a much tempered rate of 4.0 percent to 5.0 percent now. Two more episodes of cash crunches followed in September, and close to the end of November, but rates did not go past the historic highs, largely due to heavy government crackdown, hefty fines being posed, which deter many would-be investors, and businesses from taking on massive leverage positions.

The topic of shadow banking system remains as one of the most actively discussed subjects by market followers. Unless there are solutions that are fair, consistent, and are applicable to global conditions, with regular revisions/updates in between, the issues concerning the potential harm caused, costs and benefits remains unresolved, it continues to be labelled as the so-called ‘Wild, Wild West’.

About Hock Meng Tay - Chief Editor, Asia-Pacific Region

Hock Meng Tay, CAIA has written 181 post in this blog.

Chief Editor, Asia-Pacific Region Hock Meng Tay is a CAIA holder and is currently taking CFA qualification. He has over 10 years of experience working as research associate in several investment companies.He is an expert in financial analysis and has published research reports in his current role. He obtained his Masters of Business Administration in Integrated Management and Masters of Arts in Economics while serving his internship in Starsource Inc

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About Hock Meng Tay - Chief Editor, Asia-Pacific Region

Chief Editor, Asia-Pacific Region Hock Meng Tay is a CAIA holder and is currently taking CFA qualification. He has over 10 years of experience working as research associate in several investment companies.He is an expert in financial analysis and has published research reports in his current role. He obtained his Masters of Business Administration in Integrated Management and Masters of Arts in Economics while serving his internship in Starsource Inc

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