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Definition: Shadow Banking
Shadow banking is a financial arrangement for collection of non-bank financial intermediaries. It facilitates creating credit in global financial system but the members do not fall under the purview of regulatory oversight and has thus led to severe financial crisis. It can thus be categorized as unregulated activities done by regulated companies. It is touted as one of the primary reasons for the sub-prime mortgage crisis in the year 2007-08.
The term ‘Shadow banking’ was first coined by economist Paul McCulley in the year 2007 to indicate these transactions happen in the ‘shadows’. Shadow banking sometimes is said to cover money market funds, hedge funds, credit default swaps, unlisted derivatives, credit hedge funds, unlisted instruments and structured investment vehicles. They borrow short term funds in the money market and invest these to buy long-term assets. With these they turned home loans or mortgages into securities of long-term maturity. Since it does not include the traditional bank deposits, it does not come under the purview of regulation.
Hence many institutions could sustain higher financial risks but did not have the capital or liquidity to meet those risks. Hence, post the 2008 subprime crisis, shadow banking has come under severe scrutiny and the financial sector is looking for better information pertaining to shadow banking.