Procedures, Merits and Demerits of Shadow Banking

Procedures, Merits and Demerits of Shadow Banking

Tags:      Gig Economy     Economy     WTO     WTO Public Stockholding     MSP     Economic Growth     Masala Bond     Environmental Performance Index     Forecast of Economic Growth     Functions of the Finance Commission

The following are the three fundamental functions that an organization must fulfill in order to qualify as a Shadow Bank:

• The shadow bank must purchase longer-term assets with the proceeds from the sale of short-term securities. Now, the question arises as to why lenders would purchase short-term, risky securities from an unidentified company. They don't have to, in fact. A lot of these shadow banks are backed by commercial banks, either implicitly or explicitly, and as a result, they have the confidence to sell securities in government markets.

• The shadow banking institution must have liquid liabilities and relatively illiquid assets. • When making investments, the shadow bank must use additional leverage. It is possible to raise funds from other institutions to make these investments.

Merits of the Shadow Banking System - There is no regulation The absence of regulation is the only significant advantage of the shadow banking system. This advantage is significant enough to compensate for hundreds of disadvantages on its own due to the extensive regulation of the banking sector. The shadow banks are free to take on as much risk as they want without going over their financial commitments because there is no regulation on the money raised by selling securities. There is no longer a need for compliance procedures and reports that cause disruption to operations and cost millions of dollars.

Demerits of the Shadow Banking System - The disadvantages of the shadow banking system include:

No access to cash - and not having the backing of the central bank. As a result, they do not have any kind of back-up plan in case depositors suddenly want to withdraw their funds. It is true that commercial banks support these shadow banking organizations indirectly. However, when a crisis is raging, it is challenging for them to divert funds to their shadowy arm. As a result, shadow banks face significant risks not only for themselves but also for the system as a whole. This is due to the fact that their business poses the same level of risk as banks. However, they lack the safety nets or preventative regulations that banks have access to in the event that something goes wrong.

Distressed Sale - Short-term securities are sold by shadow banks to finance the purchase of long-term assets. However, these long-term assets must be sold immediately if investors become concerned about a bank's health. As a result, there are distressed sales. First, losses on these distressed sales must be recorded by the shadow bank itself. Second, as a result of the sudden increase in supply, the assets begin trading at a lower market value. As a result, other banks with such assets must mark down their balance sheets as well. As a result, perceived losses turn into actual losses, resulting in a downward spiral. Shadow banks are referred to as a "systemic risk" to the actual banking system for this reason. However, these banks have not yet been eliminated from the system due to the attraction of no regulation.

Salvage Reputation - The financial crisis of 2008 revealed numerous connections between the shadow banking system and the commercial banking system. This is due to the fact that commercial banks frequently rescued these shadowy banks when they began to fail. This would be done by commercial banks so that they can continue their operations in the future and keep their good name in the money market.

However, very few banks are now willing to engage in shadow banking as a result of the 2008 expose. Any bank that is thought to be in danger from shadow banks sees immediate declines in share prices and significant cash withdrawals. However, this phase is only brief and has occurred numerous times previously. The shadow banking system appears to grow and shrink, but, as previously stated, it does not vanish!