Why do banks offer you an umbrella when the sun is shining but want it back as soon as it starts raining? Why is that if you default ‘big’, the banks would run behind you throwing good money after bad, but if a small business is in trouble they would foreclose? Does this behavior lead to the development of shadow banking?
Such non-bank credit intermediation caused a buildup of systemic risk in many countries as they used short-term deposit-like funding for long term lending with high levels of leverage. By transforming the maturity of credit—such as from long-term to short term—shadow banks fuelled real estate bubbles in the mid 2000s that helped cause the global financial crisis when they burst. In Sri Lanka, these institutions were not subject to any regulations and caused significant risks to financial stability during 2008-2009. Due to lack of regulatory monitoring these institutions accepted deposits and when there was a ‘run’ on the deposits could not withstand the impact.Unregulated shadow institutions are used to circumvent the strictly regulated mainstream banking system and therefore avoid rules designed to prevent financial crises.
For the last four years, regulators have been focusing extraordinary efforts on ensuring that financial regulation is adequate to protect the financial system from risks emanating from the banking sector. However, it is only more recently that policy makers have turned their attention towards possible systemic risk related to entities which carry out similar functions to the banking sector or to which the banking sector is otherwise exposed. Such entities have, for convenience, can be grouped under the heading of “shadow banks”, although no precise definition or description of shadow banking has yet been agreed upon by policy makers.
The regulators should strengthen the oversight and regulation of both the formal banking sector and the shadow banking system in collaboration with standard setting bodies and rating agencies. The use of commercial papers, structured investment vehicles and other asset backed securities are in the rise again, in Sri Lanka, to suck out money market funds. Hopefully, the regulator has in mind the problems experienced in the early stages of the financial crisis, by investor runs on money market funds and the effect of sudden changes in the terms demanded by participants in the repo markets.
Banks for their part, perhaps should practice governance without taking a ‘tick the box’ approach to risk management, financial reporting standards, internal controls over financial reporting, Basel II requirements, corporate governance rules, etc. Even though, regulations are issued with prior notice for compliance, every single bank in Sri Lanka, is not ready for compliance as at the effective date, every time. They always require extensions and exemptions! Banks should therefore begin to practice in the true spirit of governance, to avoid shadow systems taking over their forte.