Explainer - What is shadow banking?

Shadow Banking

Shadow banking is a term used to describe bank-like activities (mainly lending) that take place outside the traditional banking sector. It is now commonly referred to internationally as non-bank financial intermediation or market-based finance. Shadow bank lending has a similar function to traditional bank lending. However, it is not regulated in the same way as traditional bank lending.

Examples of entities that engage in shadow banking are:

  • Bond funds
  • Money market funds
  • Finance companies
  • Special purpose entities.

How does shadow banking work?

In traditional lending, the volume of lending by a bank is linked to the volume of deposits the bank receives and what it can borrow on the markets. Shadow banking works on the same principle. So, for example, an investment fund takes in money from investors, issuing shares in the fund in return. In order to earn a return on the investment for its investors the fund uses this money to buy securities (for example, a bond issued by a country or company).

Just as the bank acts as the "middleman" between savers and borrowers to earn a specified interest rate, the investment fund acts as the channel linking investors and countries/companies to earn an investment return. By raising funds from investors and then lending this money to countries/companies, shadow banking entities act like banks.

What are the advantages/disadvantages of shadow banking?

An advantage to shadow banking is that it reduces the dependency on traditional banks as a source of credit. This is a positive benefit for the economy because it acts as an additional source of lending, and provides diversification in the financial system.

On the other hand, there is the risk that shadow banking can contribute to too much lending in the economy. This has the potential to lead to a harmful downturn.

What oversight is there of shadow banking?

There is significant regulation of most of the shadow banking system in the EU. Within Ireland, resident money market funds, investment funds and finance companies are regulated.

Irish-resident special purpose entities are not regulated by the Central Bank as a sector, as is the case in other jurisdictions.

However, the Central Bank imposes more extensive reporting requirements on special purpose entities than other jurisdictions which facilitates the monitoring of shadow banking activity.

We are also actively involved in research and international discussions on shadow banking and how best to regulate it.

How big is the shadow banking system in Ireland?

As of the end of 2017 the assets of the shadow banking system operating in Ireland is estimated at over €2.3 trillion. This is made up mostly of investment funds, money market funds and special purpose entities. They act mostly on behalf of international investors and hold non-Irish assets. This means links to the domestic economy are limited.

See also: