Shadow banking

Shadow banking refers to financial activities—especially lending and credit intermediation—that take place outside the traditional banking system. It is also known as non-bank financial intermediation or market-based finance.

Unlike conventional banks, these entities are generally not regulated in exactly the same manner as banks, although the extent of regulation varies across institutions and jurisdictions. The term “shadow banking” was coined by Paul McCulley in 2007.

How Does it Work?

The institutions act as financial intermediaries between investors and borrowers. They channel funds towards businesses and individuals, helping expand access to credit and supporting liquidity in the financial system.

Examples include NBFCs, hedge funds and special purpose entities.

Why it is Important?

Expands Credit Access: Non-bank financial institutions can serve borrowers who may find it difficult to obtain loans from traditional banks.

Supports Financial Inclusion: NBFCs and other non-bank lenders can reach underserved segments and provide specialised forms of credit.

Provides Liquidity: The channels help move funds from investors to borrowers, supporting economic activity.

Promotes Financial Innovation: These institutions can develop specialised lending models and financial products outside the traditional banking framework.

What are the Risks of this?

Systemic Risk: The 2008 Global Financial Crisis demonstrated that problems in this sector can spread to the wider financial system.

Interconnectedness: Shadow banks often have financial links with traditional banks. Problems in one part of the system can therefore affect other institutions.

Regulatory Gaps: Some non-bank activities may face different or lighter regulatory requirements than traditional banking, creating potential risks if oversight is inadequate.

Shadow Banking in India

In India, NBFCs form an important part of the non-bank financial intermediation system. They provide credit to sectors such as retail borrowers, MSMEs and infrastructure.

The IL&FS crisis in 2018 brought renewed attention to the risks in India’s this sector. The liquidity stress exposed concerns related to asset-liability mismatches, funding dependence and interconnectedness among financial institutions.

FAQs 

What is shadow banking?

Shadow banking refers to bank-like financial activities carried out outside the traditional banking system, particularly lending and credit intermediation.

Who coined the term shadow banking?

The term shadow banking was coined by Paul McCulley in 2007.

What are examples of this institutions?

Examples include NBFCs, hedge funds and special purpose entities.

Why it is important?

It helps expand credit access, support liquidity and provide financing to borrowers underserved by traditional banks.

Why is shadow banking considered risky?

Its interconnectedness with banks, liquidity risks, leverage and differences in regulatory oversight can allow financial problems to spread across the financial system.

What brought attention to shadow banking in India?

The IL&FS crisis of 2018 highlighted liquidity and funding risks in India’s NBFC sector and renewed focus on the country’s shadow banking system.