Definition
The term shadow banking refers to financial institutions that provide intermediary services that are similar to those offered by commercial banks. While shadow banks may provide some of the same services as commercial banks, they do not operate within the same regulatory framework.
Explanation
Non-bank financial institutions are not licensed banks; therefore, they are not under the supervision of a regulatory agency. However, they do offer services that are typically associated with the commercial banking industry. The shadow banking industry is a diverse set of financial institutions offering services such as securitization, money market funds, hedge funds, credit default swaps, and unlisted derivatives. Institutions that may engage in shadow banking activities include investment banks, insurance companies, private equity firms, brokerage houses, special purpose entities (SPE), and even payday lenders.
Shadow banks do not accept deposits from customers. This is one of their distinguishing characteristics, which also permits these institutions to escape regulatory oversight. That being said, shadow banks are oftentimes affiliated with holding companies that also operate commercial banks.
Some of the roles the shadow banking industry play include:
Transferring risk of default from the originator of a loan to a third party.
Obtaining short-term financing to invest in long-term assets.
Borrowing money to buy assets; thereby increasing the potential for greater profits and increasing leverage.
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