Shadow banking System definition, how it works
Shadow Banking System is a kind of financial transaction which is carried out by financial entities. Here you can understand the meaning of term shadow banking system in simple language.
Meaning of Shadow banking system
Shadow Banking System is a kind of financial transaction which is done by financial entities. It is a collection of financial institutions, infrastructure and practices which supports those financial transactions which are beyond the reach of current state sanctioned surveillance and regulation. Government has no control or regulation on it. In simple words, shadow banking system acts as a mediator in investor and borrowers. Hedge fund, Money Market fund, structured investment vehicle, unlisted derivatives and other unlisted instruments are some of the organizations taking support of this system.
Investment banks run a large portion of their business through shadow banking system but they themselves are not in the system. The working of investment banks is under the surveillance of Central bank and other government institutions. But these banks invest via shadow banking and don't show it in their balance sheet. Such transactions are increased a lot after year 2000. There are no deposits like depository bank in shadow banking system. Due to this reason, there cannot be any control or regulations over it.
Shadow banking system is running worldwide and the numbers of transactions under it are increasing rapidly. According to an estimate, shadow banking business had reached to the level of $10 trillions during 2007. It has been believed that this system had a great contribution in financial crises during 2007-2010. Shadow banking system had evaded regulations initially as it was not accepting traditional bank deposits. This resulted into the condition where many institutions and instruments were able to employ higher market creditability and liquidity risks. Moreover, the risks were not consistent with capital requirements. After subprime meltdown in 2008, activities in this system came under increasing investigations and regulations.
Infact, investment through shadow banking is full of risks. Risk in shadow banking system is its major vulnerability.