The term refers to the practice of banking like activities performed by non-banking finance companies, which are not subject to strict regulation. However, these institutions function as intermediaries between the investors and the borrowers, providing credit and generating liquidity in the system.
Although these entities do not accept traditional demand deposits offered by banks, they do provide services similar to what commercial banks offer. And this was one reason why they escaped regulation abroad.
The shadow banking system had overtaken the regular banking system in offering loans in US before the financial crisis erupted in 2008.
ISSUES associated with Shadow banking:
- The 2008 financial crisis has shown that shadow banking can be a source of systemic risk to the banking system. The risks can be transmitted directly and through the interconnectedness of partially-regulated entities with the banking system.
- The Reserve Bank is simply following the trend of global central banks increasing surveillance on shadow banking. Basel III norms require central banks to tighten supervision on shadow banks across the globe through steps such as defining minimum capital.
- In India, the crisis of the NBFCs that was triggered by the liquidity problems of IL&FSin 2018, has brought back the attention to shadow banking sector.