The Economics of Shadow Banking

The 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