What Is Shadow Banking?

by Stijn Claessens and Lev Ratnovski

Originally appeared at Voxeu.org 23 August 2013

There is much confusion about what shadow banking is and why it might create systemic risks. This article presents shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’. The idea that shadow banking is something that needs a backstop changes how we think about regulation. Although it won’t be easy, regulation is possible.

Backstops can come in the form of franchise value of a bank or insurance company, or a government guarantee. The need for a backstop is a crucial feature of shadow banking, which distinguishes it from the “usual” intermediated capital market activities, such as custodians, hedge funds, leasing companies, etc.

It Has Been Very Hard to ‘Define’ Shadow Banking

The Financial Stability Board (2012) describes shadow banking as –

“Credit intermediation involving entities and activities (fully or partially) outside the regular banking system”.

This is a useful benchmark, but has two weaknesses:

  • First, it may cover entities that are not commonly thought of as shadow banking, such as leasing and finance companies, credit-oriented hedge funds, corporate tax vehicles, etc. (Figure 1).
  • Second, it describes shadow banking activities as operating primarily outside banks. But in practice, many shadow banking activities, for instance, liquidity puts to securitization structured investment vehicles, collateral operations of dealer banks, repos, and so on, operate within banks, especially systemic ones (Pozsar and Singh 2011, Cetorelli and Peristiani 2012).

Both reasons make the description less insightful and less useful from an operational point of view.

Figure 1. Spectrum of financial activitiesNote: See Claessens et al. (2012) for more discussion of the mechanics of shadow banking processes.
Click to enlarge

An alternative – ‘functional’ – approach treats shadow banking as a collection of specific intermediation services. Each of them responds to its own demand factors (e.g., demand for safe assets in securitization, the need to efficiently use scarce collateral to support a large volume of secured transactions, etc). The functional view offers useful insights. It stresses that shadow banking is driven not only by regulatory arbitrage, but also by genuine demand, to which intermediaries respond. This implies that in order to effectively regulate shadow banking, one should consider the demand for its services and – crucially – understand how its services are being provided (Claessens et al. 2012).

The challenge with the functional approach is that it does not tell us what the essential characteristics of shadow banking are. While one can come up with a list of shadow banking activities today, it is unclear where to look for shadow banking activities and risks that may arise in the future. And the functional approach is challenged to distinguish activities that appear, on the face of it, similar, yet differ in their systemic risk (e.g., a commitment to provide for credit to a single firm vs. liquidity support to structured investment vehicles). Related, most studies focus on the US and say little about shadow banking elsewhere. In Europe, lending by insurance companies is sometimes called shadow banking. ‘Wealth management products’ offered by banks in China and lending by bank-affiliated finance companies in India are also called shadow banking. How much do these activities have in common with US shadow banking?

A New Way to Describe Shadow Banking: All Activities that Need A Backstop

To improve on the current approaches, we propose to describe shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’. This description captures many of the activities that are commonly referred to as shadow banking today, as shown in Figure 1. … And, in our view, it is likely to capture those activities that may become shadow banking in the future.

Why Do Shadow Banking Activities Always Need A Backstop?

Shadow banking, just like traditional banking, involves risk transformation – specifically, credit, liquidity, and maturity risks. This is well accepted by the existing literature, and fits all shadow banking activities listed in Figure 1. The purpose of risk transformation is to strip assets of ‘undesirable’ risks that certain investors do not wish to bear.

Traditional banking transforms risks on a single balance sheet. It uses the law of large numbers, monitoring, and capital cushions to ‘convert’ risky loans into safe assets – bank deposits. Shadow banking transforms risks using a different mechanism. It aims to distribute the undesirable risks across the financial system (‘sell them off’ in a diversified way). For example, in securitization shadow banking strips assets of credit and liquidity risks through tranching and providing liquidity puts (Pozsar et al. 2010, Pozsar 2011, Gennaioli et al. 2012). Or it facilitates the use of collateral to reduce counter-party exposures in repo markets and for over the counter derivatives (Gorton 2012, Acharya and Öncü 2013).1

While shadow banking uses many capital markets type tools, it differs also from traditional capital markets activities – such as trading stocks and bonds – in that it needs a backstop. This is because, while most undesirable risks can be distributed away, some residual risks, often rare and systemic ones (‘tail risks’), can remain. Examples of such residual risks include systemic liquidity risk in securitization, risks associated with large borrowers’ bankruptcy in repos and securities lending, and the systematic component of credit risk in non-bank lending (e.g., for leveraged buyouts). Shadow banking needs to show it can absorb these risks to minimise the potential exposure of the ultimate claim-holders who do not wish to bear them.

Yet shadow banking cannot generate the needed ultimate risk absorption capacity internally. The reason is that shadow-banking activities have margins that are too low. To be able to easily distribute risks across the financial system, shadow banking focuses on ‘hard information’ risks that are easy to measure, price and communicate, e.g., through credit scores. This means these services are contestable, with too low margins to generate sufficient internal capital to buffer residual risks. Therefore, shadow banking needs access to a backstop, i.e., a risk absorption capacity external to the shadow banking activity.

The backstop for shadow banking needs to be sufficiently deep. First, shadow banking usually operates on large scale, to offset significant start-up costs, e.g., of the development of infrastructure. Second, residual, ‘tail’ risks in shadow banking are often systemic, so can realise en masse.

There are two ways to obtain such a backstop. One is private – by using the franchise value of existing financial institutions. This explains why many shadow banking activities operate within large banks or transfers risks to them (as with liquidity puts in securitization). Another is public – by using explicit or implicit government guarantees. Examples include, besides the general too-big-to-fail implicit guarantee provided to the large banks active in shadow banking, the Federal Reserve securities lending facility that backstops the collateral intermediation processes, the implicit too-big-to-fail guarantees for tri-party repo clearing banks and other dealer banks (Singh 2012), the bankruptcy stay exemptions for repos which in effect guarantee the exposure of lenders (Perotti 2012), or implicit guarantees on bank-affiliated products (as widely described in the press regarding so called ‘wealth management products’ in China [See “The Economist 2013, Bloomberg 2013a,b”]) or on liabilities of non-bank finance companies (as noted for India, See Acharya et al. 2013).

The Need for A Backstop as A ‘Litmus Test’ for Shadow Banking

Assessing whether an activity requires access to a backstop to operate could be used as the key test of whether it represents shadow banking. For example, the ‘usual’ capital market activities (in the right column of Figure 1) do not need external risk absorption capacity (because some, like custodian or market-making services, involve no risk transformation, while others, like hedge funds, have high margins), and so are not shadow banking. Only activities that need a backstop – because they combine risk transformation, low margins and high scale with residual ‘tail’ risks – are systemically-important shadow banking.

Policy Implications

Acknowledging the need for a backstop as a critical feature of shadow banking offers useful policy implications:

  • First, it gives direction on where to look for new shadow banking risks: among financial activities that need franchise value or government guarantees to operate.

Non-traditional activities of banks or insurance companies are ‘prime suspects’. It is hard to point to the shadow banking-like activities which may give rise to future systemic risks conclusively, but one example could be the liquidity services provided by sponsor banks to exchange traded funds, or large-scale commercial bank backstops for leveraged buyouts.

  • Second, it explains why shadow banking poses significant macro-prudential and other regulatory challenges.

Shadow banking uses backstops to operate. Backstops reduce market discipline and thus can enable shadow banking to accumulate (systemic) risks on a large scale. In the absence of market discipline, the one force which can prevent shadow banking from accumulating risks is regulation.

  • Third, it suggests that shadow banking is almost always within regulatory reach, directly or indirectly.

Regulators can control shadow banking by affecting the ability of regulated entities to use their franchise value to support shadow banking activities (as was done in the aftermath of the crisis by limiting the ability of banks to offer liquidity support to structured investment vehicles). Or by managing the (implicit) government guarantees (as is attempted in the US Dodd-Frank Act by limiting the ability to extend the safety net to non-bank activities and entities; or by general attempts underway to reduce the too-big-to-fail problem).

  • Finally, it suggests that the migration of risks from the regulated sector to shadow banking – often suggested as a possible unintended consequence of tighter bank regulation – is a lesser problem than some fear.

Shadow banking activities cannot migrate on a large scale to areas of the financial system that do not have access to franchise values or government guarantees. This by itself does not make spotting the activity occurring within the reach of the regulator necessarily easier, but at least it narrows the task.

Editor’s note: The views expressed are those of the authors and do not represent those of the IMF.



Acharya, V & T S Öncü (2012), “A proposal for the resolution of systemically important assets and liabilities: the case of the repo market”, International Journal of Central Banking.
Acharya, V, H Khandwala & T S Öncü (2013), “The Growth of a Shadow Banking System in Emerging Markets: Evidence from India”, forthcoming in Journal of International Money and Finance.
Bloomberg (2013a), “Wealth Products Threaten China Banks on Ponzi-Scheme Risk”, 16 July.
Bloomberg (2013b), “Black Holes at China’s Shadow Banks”, 30 July.
Cetorelli, N and S Peristiani (2012), “The role of banks in asset securitization”, Federal Reserve Bank of New York Economic Policy Review, 18(2), 47-64.
Claessens, S Z Pozsar, L Ratnovski, and M Singh (2012), “Shadow Banking: Economics and Policy”, IMF Staff Discussion Note 12/12.
The Economist (2013), “China’s shadow banks: The credit kulaks”, 1 June.
Gennaioli, N A Shleifer and R W Vishny (2013), “A model of shadow banking”, The Journal of Finance, 68(4), 1331-1363.
Gorton, G and A Metrick (2012), “Securitized banking and the run on repo”, Journal of Financial Economics, 104(3), 425-451.
FSB (Financial Stability Board) (2012), “Strengthening Oversight and Regulation of Shadow Banking”, consultative document.
Perotti, E (2012). “The roots of shadow banking”, VoxEU.org, 21 June.
Pozsar, Z T Adrian, A Ashcraft, and H Boesky (2010, revised 2012), “Shadow Banking”, New York Fed Staff Report 458.
Pozsar, Z (2011), “Institutional cash pools and the Triffin dilemma of the US banking system”, IMF Working Paper 11/190.
Pozsar, Z, and M Singh (2011), “The nonbank-bank nexus and the shadow banking system”, IMF Working Paper 11/289.
Singh, M (2012), “Puts in the shadow”, IMF Working Paper 12/229.
Shin, H S (2009). “Securitisation and financial stability”, The Economic Journal 119(536), 309-332.

– – – – – – – – – –

1. Note the difference between banking as an activity and a bank as an organisational entity. Both traditional banking and shadow banking business processes can coexist within a single bank.


About the Authors

Stijn Claessens is Assistant Director in the Research Department of the International Monetary Fund where he leads the Financial Studies Division. He is also a Professor of International Finance Policy at the University of Amsterdam where he taught for three years (2001-2004). Mr. Claessens, a Dutch national, holds a Ph.D. in business economics from the Wharton School of the University of Pennsylvania (1986) and M.A. from Erasmus University, Rotterdam (1984). He started his career teaching at New York University business school (1987) and then worked earlier for fourteen years at the World Bank in various positions (1987-2001). Prior to his current position, he was Senior Adviser in the Financial and Private Sector Vice-Presidency of the World Bank (from 2004-2006). His policy and research interests are firm finance; corporate governance; internationalization of financial services; and risk management. Over his career, Mr. Claessens has provided policy advice to emerging markets in Latin America and Asia and to transition economies. His research has been published in the Journal of Financial Economics, Journal of Finance and Quarterly Journal of Economics. He had edited several books, including International Financial Contagion (Kluwer 2001) Resolution of Financial Distress (World Bank Institute 2001), and A Reader in International Corporate Finance (World Bank). He is a fellow of the London-based CEPR.
Lev Ratnovski is an economist at the Research Department of the International Monetary Fund. He focuses on international banking and finance issues. Previously, he worked on the United States and Canada desks of the IMF (2008-10) and in the Financial Stability area of the Bank of England (2006-08). Mr. Ratnovski holds a B.Sc. from HSE-Moscow and a Ph.D. from the University of Amsterdam.
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