Shadow banking as the symptom and not the disease

A friend pointed me to an interesting new book recently, “Inside China’s Shadow Banking: the Next Subprime Crisis”. This is written by an investment banker turned shadow banker, Joe Zhang. His anxious nine year old asked him if he was going to become a “small loan shark” in this transition. The book is a fascinating account of businesses that operate at the periphery of the banking sector in China and the consequences of prolonged negative real rates of interest combined with a banking sector subject to stringent licensing (sound familiar?).

This book also got me thinking how the term “shadow banking” has acquired so much currency in recent years since the US credit crisis. This rather unflattering term is used to refer to an entire spectrum of financial firms including hedge funds on the one end in the US and unlicensed deposit-takers like Saradha Chit Fund in India and micro-credit firms in China on the other. Irrespective of exact identity, being a shadow bank clearly connotes weak to non-existent regulation and risks to customers. A throwback to Shylock, if you will.

Why do these exist and why do regulators tolerate them? As Zhang rightly points out and a few commentators observed post-Saradha, shutting down shadow banks can be done but amounts to shooting the messenger. The real culprit is financial repression. In the absence of high-quality, formal options to save, invest and borrow, people are forced to deal with the more “shadowy” segments of the financial system. In its extreme form, investments in financial assets of any form are rejected in favour of physical assets. In its Financial Stability Report, RBI acknowledges that “the shift from financial assets to real estate and gold has become stark. Inflation, low penetration of banking services, credibility of financial institutions in the wake of mis-selling of products and financial frauds, low post-tax returns on bank deposits, negative/low real interest rates etc could be some of the issues that need to be addressed to re-direct non-financial savings towards financial savings”.

Given all of the challenges of an evolving banking sector in India and China and in the tradition of second-best approaches, maybe there is a two-stage evolution to consider -- from physical savings (real estate and gold) to dealing with reputable regulated shadow banks and then over time from reputable regulated shadow banks to reputable regulated banks.

Do reputable regulated shadow banks even exist? Viral Acharya and his co-authors at CAFRAL recently published an excellent paper that looked at the shadow banking system in India, specifically, the non-deposit taking finance companies. They find significant complementarity between the presence and activities of the banking sector and the non-deposit taking finance companies, rather than overlaps. They caution that micro- and macro-prudential considerations of such shadow banks or non-bank finance companies in emerging markets like India may not necessarily resemble those in the developed economies and needs to be understood better.

This may well be an interesting path for India to escape the tyranny of financial repression.

The thoughts and opinions shared here are of the author.