“Shadow banking is often seen as a form of regulatory arbitrage. It surely has such aspects, and they played a significant role in the run-up to global financial crisis. But beyond that, shadow banking also provides important financial intermediation functions distinct from those performed by banks and capital markets, as confirmed by its continued growth. These functions can be economically useful, and need to be understood and properly regulated. The traditional Financial Stability Board (FSB, 2011) definition of shadow banking (credit intermediation involving entities and activities outside the regular banking system) may be too broad for policy analysis. This paper focuses on two functions of the shadow banking system that are most close economically to those of traditional banks: securitization and collateral intermediation. Both assist in intermediating funds from savers to investors, and both involve risk transformation.
After describing these two main functions, the paper reviews their economic values, highlighting how they cater to various demands. The securitization function, operating through the prime money funds complex, serves the needs of large institutional cash pools that seek safe, short-term investments and more controversially the demand of banks for assets that can be used to secure repo funding. And the collateral intermediation complex specializes in the efficient use of scarce collateral.”
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