Shadow Banking

Shadow banking is a system of lending money through capital markets without adequately recording this in a company’s financial reports, in contrast to ‘traditional’ bank lending, which is based on money deposited in a bank. It grew up largely as a means for banks to get around capital requirements – the minimal levels of readily accessible capital (such as cash and shares) that they are legally required to hold on to by national regulators, in accordance with the Basel Accords. As such, shadow banking is not an alternative to regular banking but part of a broader transformation in how banks operate. Commercial and investment banks are major players in this new system, alongside other institutional investors (e.g. pension funds, sovereign wealth funds and banks) and traders operating on behalf of hedge funds, mutual funds or private equity firms.

Shadow banking operates through the creation of new companies, known as special purpose vehicles, ‘conduits’ or ‘structured investment vehicles’, which are designed to take lending off the balance sheets of banks or other financial institutions. These off-balance sheet companies are generally set up in offshore tax havens (also called ‘secrecy jurisdictions’), both to avoid taxes and as a means to circumvent regulation (a process sometimes referred to as ‘regulatory arbitrage’). The off-balance sheet companies then take up various forms of securitized debt (such as asset-backed securities, collateralized debt obligations and credit default swaps). Around $20 trillion was taken off bank balance sheets in this way in 2007, shortly before the financial crisis hit.

The overall effect is to spread significant risks throughout the whole financial system. Shadow banking is similar to a Ponzi scheme, with a constant flow of new short-term borrowing required in order to keep up with longer-term loans. When the momentum stops, the scheme collapses, as happened in 2008.

The new Basel III banking regulations address some of these failings, but it is likely that ‘regulatory arbitrage’ will also increase as banks and other financial institutions look for new off-balance sheet possibilities. This has a potential impact on climate finance, with banks liable to shift project finance onto capital markets in order to ‘free up’ space on their balance sheets for lending that cannot so easily be hidden away. Many forms of climate-related lending already used the off-balance sheet companies and structures that characterize the shadow banking system.