The Economics of Shadow Banking

Manmohan Singh

collateral-plumbing-bookThe couple of decades leading up to the Lehman crisis in 2008 witnessed rapid growth in financial intermediation whereby non-banks interact with banks. Coined under the rubric of shadow banking, the banknon-bank nexus is largely seen as a form of regulatory arbitrage. However, this is an incomplete view, since there is genuine economic demand for such services. This chapter11Written for the Reserve Bank of Australias Funding and Liquidity Conference, Sydney (August 2013).attempts to explain the economics that supports the demand/supply for this market, the systemic risks that can arise and the regulatory and broader policy implications.

To formulate a policy response to shadow banking, we need to understand the nuts and bolts of how these markets work. Collateral is used in a wide range of financial transactions: secured funding (mostly by non-bank investors), repurchase agreements (or repo), and hedging (primarily with over-the-counter (OTC) derivatives). As collateral is increasingly scarce, a key shadow-banking function is to mobilise and reuse collateral to support a large volume of transactions. So there is use of capital in shadow banking in the form of margins and

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