CENTRAL BANK OF NIGERIA

UNDERSTANDING MONETARY POLICY SERIES

NO 39

c 2014 Central Bank of Nigeria

SHADOW BANKING

George Okorie George Okorie George Okorie

10TH

ICYL DO EP PY AR RA TT ME EN NO TM

AnniversaryCommemorative

Edition

Central Bank of Nigeria33 Tafawa Balewa WayCentral Business DistrictsP.M.B. 0187Garki, AbujaPhone: +234(0)946236011Fax: +234(0)946236012Website: E-mail:

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ISBN:

© Central Bank of Nigeria

978-978-52861-1-3

iii

Central Bank of Nigeria

Understanding Monetary Policy

Series 39, March 2014

EDITORIAL TEAM

EDITOR-IN-CHIEF

MANAGING EDITOR

EDITOR

ASSOCIATE EDITORS

Aims and Scope

Subscription and Copyright

Correspondence

Email:info.dmp@cbn.gov.ng

Moses K. Tule

Ademola Bamidele

Charles C. Ezema

Victor U. ObohDavid E. Omoregie

Umar B. Ndako Agwu S. Okoro

Adegoke I. AdelekeOluwafemi I. Ajayi Sunday Oladunni

Understanding Monetary Policy Series are designed to improve monetary policy communication as well as economic literacy. The series attempt to bring the technical aspects of monetary policy closer to the critical stakeholders who may not have had formal training in Monetary Management. The contents of the publication are therefore, intended for general information only. While necessary care was taken to ensure the inclusion of information in the publication to aid proper understanding of the monetary policy process and concepts, the Bank would not be liable for the interpretation or application of any piece of information contained herein.

Subscription to Understanding Monetary Policy Series is available to the general public free of charge. The copyright of this publication is vested in the Central Bank of Nigeria. However, contents may be cited, reproduced, stored or transmitted without permission. Nonetheless, due credit must be given to the Central Bank of Nigeria.

Enquiries concerning this publication should be forwarded to: Director, Monetary

Policy Department, Central Bank of Nigeria, P.M.B. 0187, Garki, Abuja, Nigeria,

iv

Central Bank of Nigeria

Mandate

Vision

Mission Statement

Core Values

§Ensure monetary and price stability

§Issue legal tender currency in Nigeria

§Maintain external reserves to safeguard the international

value of the legal tender currency

§Promote a sound financial system in Nigeria

§Act as banker and provide economic and financial

advice to the Federal Government

“By 2015, be the model Central Bank delivering

Price and Financial System Stability and promoting

Sustainable Economic Development”

“To be proactive in providing a stable framework for the

economic development of Nigeria through the

effective, efficient and transparent implementation

of monetary and exchange rate policy and

management of the financial sector”

§Meritocracy

§Leadership

§Learning

§Customer-Focus

v

MONETARY POLICY DEPARTMENT

Mandate

To Facilitate the Conceptualization and Design of

Monetary Policy of the Central Bank of Nigeria

Vision

To be Efficient and Effective in Promoting the

Attainment and Sustenance of Monetary and

Price Stability Objective of the

Central Bank of Nigeria

Mission

To Provide a Dynamic Evidence-based

Analytical Framework for the Formulation and

Implementation of Monetary Policy for

Optimal Economic Growth

The understanding monetary policy series is designed to support the communication of monetary policy by the Central Bank of Nigeria (CBN). The series therefore, provides a platform for explaining the basic concepts/operations, required to effectively understand the monetary policy of the Bank.

Monetary policy remains a very vague subject area to the vast majority of people; in spite of the abundance of literature available on the subject matter, most of which tend to adopt a formal and rigorous professional approach, typical of macroeconomic analysis. However, most public analysts tend to pontificate on what direction monetary policy should be, and are quick to identify when in their opinion, the Central Bank has taken a wrong turn in its monetary policy, often however, wrongly because they do not have the data for such back of the envelope analysis.

In this series, public policy makers, policy analysts, businessmen, politicians, public sector administrators and other professionals, who are keen to learn the basic concepts of monetary policy and some technical aspects of central banking and their applications, would be treated to a menu of key monetary policy subject areas and may also have an opportunity to enrich their knowledge base of the key issues. In order to achieve the primary objective of the series therefore, our target audience include people with little or no knowledge of macroeconomics and the science of central banking and yet are keen to follow the debate on monetary policy issues, and have a vision to extract beneficial information from the process, and the audience for whom decisions of the central bank makes them crucial stakeholders. The series will therefore, be useful not only to policy makers, businessmen, academicians and investors, but to a wide range of people from all walks of life.

As a central bank, we hope that this series will help improve the level of literacy in monetary policy as well as demystify the general idea surrounding monetary policy formulation. We welcome insights from the public as we look forward to delivering content that directly address the requirements of our readers and to ensure that the series are constantly updated as well as being widely and readily available to the stakeholders.

Moses K. TuleDirector, Monetary Policy DepartmentCentral Bank of Nigeria

FOREWORD

CONTENTS

vii

Section One: Introduction

Section Two: Conceptual Issues

Section Three: Characteristics of Shadow Banks

Section Four: Rationale for the Existence of Shadow Banking System in the WAMZ

Section Five: Risk Concerns in the Shadow Banking System

Section Six: Regulating the Shadow Banking System

Section Seven: Shadow Banking – Global Experience

Section Eight: Current and Potential Approaches for Monitoring the Shadow Banking System

Section Nine: Conclusions

Bibliography

.. .. .. .. .. .. 1

.. .. .. .. .. 3

.. .. .. 7

2.1 Bank and Banking2.2 What is Shadow Banking? .. .. .. .. .. 3

3.1 How Shadow Banks Operate .. .. .. .. .. 7

.. .. .. .. .. .. 94.1 Need for Shadow Banking .. .. .. .. .. 9

.. .. 115.1 Shadow Banking and the Global Financial Crisis of 2007 – 2008 11

.. .. .. 13

.. .. 157.1 Shadow Banking in Nigeria .. .. .. .. .. 16

.. .. .. .. 17

.. .. .. .. .. .. 19

.. .. .. .. .. .. .. .. 21

.. .. .. .. .. .. 3

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S H A D O W B A N K I N G 1

George Okorie 2

SECTION ONE

Introduction

Shadow banking is a concept that refers to financial activities that take place

outside the regulated banking sector. This implies that such financial activities or

transactions are not adequately subjected to the rigours of supervision and

regulation, compared to those in the formal financial system. Shadow banking,

or parallel banking therefore, as is often called, constitute significant risks to the

financial system as it also interacts with regulated banks. The provision of short

term collaterized debt to financial institutions by shadow banking entities has

grown over the years. These loans are usually for long term purposes. The inherent

maturity and liquidity mismatch, poses systemic risk for the financial system. If the

risks are substantial, panics arise and consequently a run on shadow banking

instruments and entities occur.

A major cause of the 2007 - 2008 global financial crises was the maturity

mismatch in the shadow banking sector. The sector funded long term projects

from short term sources, which eventually increased default rates, particularly in

the housing sector.

In recent years, especially since the financial crisis, many aspects of the shadow

banking system have had relatively negative publicity and have come under

severe criticism. Certain credit and financial functions outside the traditional or

regulated banking system have been described as illegal, having operated

outside the law i.e., outside prudential regulation and supervision. However, in

general, many of these alternative credit and financial functions have important

economic and financial markets rationale, and many aspects of their operations

are actually directly or indirectly regulated and monitored.

1This publication is not a product of rigorous empirical research. It is designed specifically

as an educational material for enlightenment on the monetary policy of the Bank.

Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the

accuracy of the contents of this publication as it does not represent the official views or

position of the Bank on the subject matter.

2George Okorie is Principal Economist, in the Monetary Policy Department, Central Bank of

Nigeria

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This brief undertakes a discussion of shadow banking to create a general

understanding of the major conceptual issues, its operations, risks and efforts at

providing regulation and supervision for shadow banks to make them less risky to

the financial system. Following this introduction, Section-two looks at some

conceptual issues. Section-three reviews the characteristics of shadow banking

and how shadow banks operate, while Section-four looks at the rationale for the

existence of shadow banks. Section-five examines shadow banking as a systemic

risk concern and also discusses shadow banking and the 2007-08 global financial

crises. Section-six highlights global recommendations for regulating the shadow

banking system. Section-Seven reviews global and domestic experience with

shadow banking. Section-eight looks at the current and potential approaches for

monitoring the shadow banking system, while section-nine concludes.

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SECTION TWO

Conceptual Issues

2.1 Bank and Banking

Banks are financial institutions that acquire funds from surplus units for onward

lending to deficit units. One major role of banks is that of maturity transformation.

Essentially, while lenders prefer deposits to be held by banks for a short period,

borrowers usually require loans for longer periods. Therefore, banks retain a

portion of their deposits in liquid assets in order to meet depositors‘ demand for

cash. However, by performing this financial intermediary role between owners of

surplus funds and borrowers of these funds, a bank is essentially exposed to risk.

The risk stems from the fact that banks are usually victims of bank-run, a situation

where depositors arrive at the bank at the same time requesting for their money.

When the need arises, banks liquidate their assets, to ensure that depositors‘

demands are met. A loss in asset value is suffered by banks while liquidating their

assets under short notice. Illiquidity in the banking system could lead to insolvency

and eventual collapse or failure of the system. At the slightest hint of distress,

rational depositors move quickly to withdraw their fund.

In periods of crisis, banks usually require deposit insurance or bail-out funds from

the central bank (Noeth and Sengupta, 2011).

2.2 What is Shadow Banking?

Shadow banks are financial institutions that carry-out financial intermediation

activities outside the central bank supervision and regulation framework. The most

important of such activities in recent times involves the provision of short-term

debt to financial institutions, in the form of money market funds and other

sources. Gennaioli et al, 2013 notes that shadow banks compete with regular

banks in the provision of financial services to the public and businesses.

Shadow banks comprise intermediaries such as investment banks, money-market

mutual funds (MMMFs), mortgage banks, finance houses, asset-backed

commercial paper ('ABCP') channels, and hedge funds. Services include: sale-

and-repurchase agreements (repos); and instruments such as asset-backed

securities (ABSs), collateralized debt obligations (CDOs), asset-backed

commercial paper (ABCP), and structured investment vehicles (SIVs), among

others.

A shadow banking arrangement can be in the form of a single entity or multiple

entities.

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Repo and Reverse Repo Transactions3

Repo, or repurchase transaction is a situation where securities are bought and

resold after a while. Essentially, repos are short-term debt instruments. Repo

transactions can be rolled over as required. The assets derive their safety from the

underlying security which the seller offers the buyer at the time of transaction. The

security can be sold by the lender in order to recover the money invested. Excess

collateral can be used to support repo transactions, in order to strengthen the

safety of the transaction.

Money Market Mutual Funds

Money Market Mutual Funds (MMMFs) are short term investment outlets that are

redeemable on demand. The safety of the investments lies in the fact that they

are of superior quality and matures within a short while. Example of MMMFs is

treasury bills and high quality commercial paper.

Securitisation

Securitization is the practice of combining different types of debt instruments such

as mortgages, and trading them as bonds or collateralized mortgage obligation

(CMOs) to interested investors. Principal and interest on the debt are paid back

to investors in due course.

Asset-backed Commercial Paper (ABCP)

Asset-backed Commercial Paper (ABCP) is typically a short-term instrument that

matures within 30 days from the date of issuance. It is usually financed by a

financial institution such as a bank, which sells ABCP to ―safe asset‖ investors.

Asset-backed Securities

Asset-backed securities (ABS) are financial assets whose values are backed up by

a group of underlying assets. These assets are characteristically small and illiquid

and therefore cannot be individually sold. Combining the assets makes it easier

for them to be sold, thereby allowing for diversification of individual risks. Special

purpose vehicle (SPV) is established to manage the securitization of asset backed

securities.

Over-the-Counter (OTC)

Over-the-counter (OTC) is a trade done outside the stock exchange. It is a direct

transaction between two parties. While the Exchange ensures transparency in

dealing with trading parties, the OTC market lacks this quality. Items transacted in

3 Materials in the following bullet points were cculled from Wikipedia – the Free

Encyclopedia, 2014

SHADOW BANKING

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the market include commodities, stocks, derivatives, etc. Inability of a company

to afford listing requirements of a stock exchange drives it to trade its stocks over-

the-counter.

Leverage

Leverage is the financial practice of using borrowed funds to buy assets, in the

belief that the financial gains that would arise from the sale of the assets, would

be able to cover the cost of borrowing. This however, involves the risk of not been

able to repay the loan should the value of the assets at maturity fall below the

cost of borrowing.

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SECTION THREE

Characteristics of Shadow Banks

Following the existing definition and operations of shadow banks, Schwarcz (2012)

observes that:

Traditional banks are better regulated than shadow banks

Regulatory arbitrage (regulation avoidance) encourages the growth of

shadow banking. Increasing regulation for traditional banks will largely

lead to an increase in shadow bank entities.

Shadow banking encourages competition in the provision of financial

products and services. This could increase both efficiency and risk in the

financial system.

The more shadow banks are left unregulated, the more they pose threats

to the financial system. A major cause of asset bubbles in the real estate

market during the global financial crisis was maturity mismatch, which

characterised the shadow banking system. The practice of utilising short-

term funds for long-term financing requirements, as is the case in the

shadow banking system, fosters liquidity risks.

Shadow banking not only provides short-term financing, but in special

cases, also provides long-term funding.

Shadow banks are known to use technology to provide varied, state-of-

the-art financial services. Traditional banks fall behind non-bank financial

institutions, in the efficient use of technology to provide financial services.

3.1 How Shadow Banks Operate

The provision of inadequately supervised and regulated financial products and

services by non-bank financial institutions, raise systemic risks concerns for

regulatory authorities. Shadow banks raise funds from the public, through short-

term or redeemable instruments such as repos. These funds are then converted

into not so liquid assets such as mortgages. They can also be re-invested to

accumulate leverage. While regular banks provide similar financial services, the

risk profile is usually less compared with shadow banks, because they are offered

without formal approval, or subjected to the same prudential guidelines,

standards and supervision rendered to regular banks.

If the shadow banking system continues to function without bearing the full cost

of its actions due to the absence of formal supervision and approvals, it is likely to

enjoy undue funding advantage over regular banks, and consequently build up

additional risks in the system. Also, this helps to create arbitrage opportunities that

SHADOW BANKING

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are capable of undermining prudential regulation, thus fuelling additional risks in

the system.

On the other hand, banks can create parallel banking units, in order to increase

leverage and avoid regulatory requirements such as liquidity ratios, cash reserve

requirements etc.

These activities hide risks, which become apparent in times of stress. While

investing in risky assets, banks benefit from higher returns, while tax payers are left

to bailout the distressed institutions.

Shadow banking activities creates significant moral hazards for banks. In order to

prevent moral hazards, prudential regulation requires banks to hold considerable

amount of capital in their balance sheets i.e., risk weighted capital adequacy

ratio. In most cases, banks create off-balance sheet depositories for their risky

assets, thereby misleading bank examiners and reducing their obligation to

prudential requirements.

In the shadow banking system, wholesale investors provide funds, using the repo

market and money market operators such as money market mutual funds, for

short-term loans that are redeemable on request (Noeth and Sengupta, 2011).

SHADOW BANKING

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SECTION FOUR

Rationale for the Existence of Shadow Banking System

An appropriate starting point for any discussion of the shadow or parallel banking

system would be to answer the question: is there a need for it? Often times, the

belief is that it serves a useful purpose, considering certain unavoidable structural

issues in the traditional banking system, which includes:

the high asset-to-deposit ratio of the banks, which means that they need

constant flow of market funding in order to perform their main functions of

credit creation and maturity transformation for economic growth and

development;

the increasing funding need of the consumer or the corporate, for funding

beyond the established parameters of the regulated banking system, and

strictly regulated lending criteria;

reduced credit creation by the traditional banks and increased funding

gap, which urgently calls for attention;

the imperative facing traditional banks to shed risk and manage the

availability of credit lines i.e., traditional regulated banks may be good at

extending loans, but they may not be able to finance them for a

prolonged period of time — it may be costly from a capital point of view,

it may require high liquidity levels, or it may jam the balance sheet; and

the de-risking and the limitations of the traditional banks creates the need

for another sector to take the credit, interest rate and other risks inherent

in financial and credit intermediation.

4.1 Need for Shadow Banking

While shadow banking often takes place outside the regulated banking

system, such financial practice, if properly conducted, can be a useful

complement to bank financing and provide strong support for economic

activity;

Shadow banking is indeed a sign of financial improvement, which can

help to increase both flexibility and efficiency in financial intermediation;

It can increase financial deepening, lead to the development of financial

markets and new financial instruments;

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Securitization, which is a major feature of shadow banking, encourages

the diversification of risks and cost reduction in financial intermediation.

By providing an array of securities with varying maturity and risk, it provides

financial institutions the opportunities to better manage their portfolios.

Regardless of popular belief, parallel banking as is often called, has aided

increased transparency in finance, as banks now transact assets that

could have been held as off-balance sheet items.

In general, the shadow banking system can be viewed as a useful complement

to traditional banking. The major challenge ahead is on how to reduce the

associated risks and efficiently utilise the benefits.

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SECTION FIVE

Risk Concerns in the Shadow Banking System

Decentralization is a major feature of the shadow banking system, which

facilitates market division (into small pieces), connectedness and

inconspicuousness. It also makes information difficult to access and process by

market participants. Consequently, risks are covered, unchecked and

undetected. When these risks crystallise, market players are gripped with fear,

which often lead to runs on shadow-banks and their products such as repos. The

substantial drop in the value of mortgage backed securities during the last

financial crises prompted repo lenders to ask for additional collateral,

necessitating bank repo-holders to sell-off assets in order to generate additional

guarantees (Schwarcz 2012). Also, declines in underwriting standards are

believed to have played a major part in the 2007-08 financial crises.

The financial assets that serve as securities or guarantees for Asset-backed

Commercial Papers (ABCPs) comprise of different asset classes such as Asset-

backed Commercial Papers, Residential Mortgages, Commercial Loans and

Collateral Debt Obligation (CDOs). Prior to the global financial crisis that started in

August 2007, most of these assets were rated AAA by reputable rating agencies,

which meant that they have a low default risk. In the run-up to the crisis, many

large institutions were heavily exposed to these assets, given their attractiveness

and high ratings. Following the crisis however, most of these assets fell in value,

making investors much unwilling to buy ABCPs or roll them over.

This development caused maturity mismatch for financial institutions that

depended on ABCP to obtain short term liquidity for long term purposes. Given

the reluctance of investors to purchase or roll over ABCP, affected banks were

left with no option but to discharge their long-term investments at a considerable

loss. These events crystallised in a liquidity shock to the banking system, which

helped in precipitating the crisis.

5.1 Shadow Banking and the Global Financial Crisis of 2007 – 2008

The financial crisis of 2007 - 08 was essentially an abandonment of various so

called "safe" assets and securities. A major origin of the crisis was the fall in

residential mortgage prices, which adversely impacted on subprime mortgages.

Asset Backed Securities (ABSs) connected to subprime mortgages rapidly fell in

value. The shock to home prices spread to other assets, as short term investments

were unable to be rolled over. Basically, there was an abandonment of short-

term debt. The repo market, the market for ABCP, and MMMFs were hard hit.

Gorton (2010) argues that the major cause of the financial crisis was a run on the

SHADOW BANKING

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repo market. The run arose as repo investors sold off repo collateral at

considerable loss, following the excess supply of repo.

Gorton and Metrick (2014), observes that the nature of this run on repos and the

repo market, were comparable to previous panics in the banking sector, where

hitherto safe and liquid assets unexpectedly became unsafe. Essentially, asset

backed securities; securitization and AAA-rated securities suddenly became

unsafe, lost investor confidence and were not free from information asymmetry,

adverse selection and moral hazards. Since evaluating these securities entailed

significant costs, investors were left with no alternative than to exit them.

The global financial crisis demonstrates how stress and shocks can destabilise the

financial system. Vulnerabilities arise from both the regulated and unregulated

institutions, given the complex web of exposures and interconnectedness of the

financial system. Lessons from the GFC have reinforced the need for regulatory

authorities to take a consolidated and global approach to financial system

supervision and regulation, and to discover vulnerabilities in the system even

before they manifest, in order to ensure the stability of the global financial system.

(Gravelle et al, 2013).

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SECTION SIX

Regulating the Shadow Banking System

The existence of finance outside the boundary of regulation requires a broader

approach to supervision and regulation, which should dwell on both financial

activities and institutions, with prominence given to risk and transparency. In

November 2010, the G20 leaders in Seoul emphasized the urgent need to accord

stiff regulation on shadow banks. It thereafter, mandated the Financial Stability

Board (FSB) and related bodies to design a blue print on how this task could be

carried out by the middle of 2011.

The shadow banking system through its association with regular commercial

banks, has proven to be a major source of risk and financial system instability. It

also creates avenues for arbitrage, which undermines prudential regulation. It is

therefore, important to improve supervision and regulation of the shadow

banking system, in order to effectively address risk and arbitrage concerns.

In reaction to the G20‘s request, the Financial Stability Board (FSB) set up a task

force to make necessary recommendations for supervising and regulating the

system.

In a related development, (Gravelle et al, 2013), recommends that the regulatory

measures should be:

Directed at the risks created by the shadow banking system;

Equivalent to the risks to the financial system;

Futuristic and flexible enough to address evolving risks;

Implementable;

Bridge international and jurisdictional differences in application; and

Improvable and Implementable

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SECTION SEVEN

Shadow Banking – Global Experience4

Advanced economies

Supervisory arbitrage stimulated the evolution of securitization in Europe

and the United States, and inspired the introduction of CDOs and SIVs in

the late 1980s, which all became strengthened in the mid-2000s.

Low real interest rates have been a major driver of growth of MMFs in the

United States. MMFs originated out of the need to avoid increasingly

negative real interest rates on regulated deposits during times of high

inflation. Nevertheless, bank regulation, now in the form of limits on

deposit insurance, contributes to demand for MMFs as the limits induce

large depositors to seek higher returns on claims with nonbank financial

institutions.

Investors‘ search for yield, which started in the mid-2000s, helped in the

development of hedge and private equity funds, and encouraged the

fast growth of structured finance and investment funds. In the euro area,

low sovereign yields and ample liquidity in global financial markets were

instrumental in motivating investors to pursue higher returns in riskier

markets.

Emerging market economies

Firm restrictions on banks were major in the emergence and growth of

Chinese shadow banking activities. Off balance sheet loan arrangements

increased, in reaction to lending restrictions (including quotas) on banks

by the Chinese authorities during periods of rising inflation.

In Mexico, regulatory arbitrage and government support encouraged the

growth of shadow banking institutions (Sofoles). These entities, which were

unregulated, provided financing for lower- and middle-income

households in the informal sector. Still riding on government support, their

mortgage-backed securities received the best credit ratings. At the onset

of the crisis, however, Sofoles was severely hit.

In India, banking activity is complemented by nonbank financial

institutions, especially as they help to facilitate the allocation of credit to

4 This Section draws immensely from ―Shadow Banking around the Globe: How Large and

How Risky‖, by Nico Valckx et al, International Monetary Fund, October 2014.

SHADOW BANKING

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the rural Indian economy, thereby helping commercial banks to meet

their legal targets.

In Brazil, assets of investment funds increased from 25.0 to 50.0 per cent of

GDP in the period 2002 - 2013. Search for yield when real interest rates

were down and increase in institutional investors such as pension funds

and insurance companies, partly contributed to this growth.

From the review of country experiences, it is observed that tight bank regulations,

search for yield, particularly in periods of low interest rates and high inflation; and

the need to deepen the financial system, boosted the growth of shadow

banking. Financial environment in advanced countries, appear conducive to the

sustained growth in shadow banking activities.

7.1 Shadow Banking in Nigeria

The financial derivatives markets in Nigeria are still evolving, especially in over-the-

counter (OTC). Plans are underway to introduce a derivatives exchange, where

more sophisticated instruments are traded to attract foreign investors. The CBN

issued guidelines for the introduction of FX derivatives on March 22, 2011 as a

hedging strategy in the foreign exchange market. The Nigerian Stock Exchange

(NSE) intends to open options market (stock options, bond options and index

options) by 2014 and futures market by 2016 (Tule, 2014). A Securitization Bill,

which includes derivatives trading, is before the National Assembly.

Apart from derivatives trading, a growing amount of shadow banking activities

also exists in Nigeria. As such, Nigeria‘s Financial Stability Review should take a

broader look at the development of the shadow banking system in Nigeria,

including its main subsectors, scale of activities and risks to the financial system. It

should also establish a risk assessment and monitoring framework. The framework

should address issues of maturity transformation, liquidity transformation, leverage,

and imperfect credit-risk transfer.

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SECTION EIGHT

Current and Potential Approaches for Monitoring the Shadow

Banking System

In regulating the shadow banking system authorities, particularly the central

bank, should adopt both macro and micro based approaches.

While the Macro approach utilizes quantitative information obtained from flow of

funds and sectoral balance sheet data (the IMF has provided monetary

authorities with updated templates for capturing this information on a regular

basis); the Micro approach makes use of quantitative and qualitative information.

The aim of the Macro approach is to relate the size of the shadow banking assets

with the size of the economy and the financial system. Under the Micro

approach, quantitative data are used to measure the scale and scope of

activities in the shadow banking system. Interconnectedness of the financial

system and counterparty exposures, which this approach reveals, help the

regulatory authorities to monitor systemic risks and possible spillovers, and to stand

ready to mitigate adverse developments in the system.

Qualitative information on the other hand, is obtained through market

intelligence surveys and regular interactions with market watchers and

participants. This information also provides early warning signals to regulators,

which enables them to act on time to mitigate anticipated risks.

Regulatory response to shadow banking should be balanced, targeted at the

risks emanating from the system, forward-looking and flexible, and improve with

time.

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SHADOW BANKING

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SECTION NINE

Conclusion

Shadow banking plays a complementary role in the provision of financial services

in the financial system. Through the use of information technology, the system has

developed cutting edge financial products and services, thereby increasing

access to credit, improving market liquidity, facilitating maturity transformation,

and risk sharing.

It, however, comes with associated risks, as evidenced in the 2007–08 global

financial crises. The crisis, lends solid voice to the call for effective regulation of

these non-bank financial institutions, since given the interconnectedness of the

system, systemic risks can originate from the fragmented parts. This fact buttresses

the need for regulators to be awake to their role and closely monitor the growth

of the shadow banking system in order to appreciate the promoters of this

activity by providing the needed regulatory support.

The objective of such monitoring should be to support the positive aspects of the

system, while activities that pose extreme risks are restrained.

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(2014). ―Shadow Banking around the Globe: How Large and How Risky‖,

International Monetary Fund

Wikipedia - the Free Encyclopaedia (2014).

SHADOW BANKING

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