Lately, there’s been a lot of talk about shadow banking, specifically its follies and pitfalls. Even the name “shadow banking” evokes shady images of people trying to sell loans in dark alleys. But what is shadow banking, and how big is the market in Canada? What are its dangers, and what has been the policy response from regulators to date? Are there still unanswered questions from that policy response?

Shadow banking is best defined by its economic function. Regulators, such as the Bank of Canada , the Federal Reserve Board, and the Financial Stability Board, commonly define it as “non-bank credit intermediation resulting in maturity or liquidity transformation.” In Canada, this typically refers to such lending as car loans through dealership finance companies or non-bank mortgage lenders. These loans are financed through market-based funding mechanisms, such as securitization, money market funds, repos, and commercial paper.

As a proportion of the regular banking system, Canada’s shadow banking market is estimated to be relatively small (between 20−30 percent of traditional banking liabilities), especially compared to the United States (closer to 90 percent). It shrank considerably in Canada after the financial crisis for two reasons: a consumer flight to safety by the regulated sector and the adoption of International Financial Reporting Standards (IFRS). IFRS adoption added almost $300 billion in mortgage-backed securities to the balance sheets of chartered banks, and as a result, these exposures came under the umbrella of the federal banking watchdog, the Office of the Superintendent of Financial Institutions (OSFI).

Shadow bank financing vehicles do not have a government backstop, such as deposit insurance, or access to central bank liquidity facilities and thus have traditionally avoided safety and soundness regulation. As a result, they have lower compliance costs that allow them to offer pricing lower than the regulated system. However, in a low interest-rate environment, this can cause the systemic, pro-cyclical buildup of leverage, leading to asset bubbles, such as the one that the U.S. real estate market recently experienced. Market-based funding activities, which are designed to transfer credit risk from one party to another, may actually create other risks, including operational risks, such as collateral maintenance and/or enforcement. These risks make shadow banks more susceptible to market dislocations, such as “runs” or freezes.

After the 2008 financial crisis, global regulators took a closer look at the systemic risk associated with shadow banking. The Financial Stability Board (FSB) recently published draft guidance on shadow banking, proposing four overarching principles to improve oversight of the sector:

1. Defining shadow banking for a particular jurisdiction;
2. Collecting relevant information to assess shadow banking risks;
3. Enhancing disclosure of shadow banking entities; and
4. Assessing these entities based on their economic function, not just on their legal form.

In addition, the FSB proposed policy options that could be used by regulatory authorities to help address risks associated with market-based funding mechanisms. These include maturity and leverage limits, liquidity buffers, and redemption pressure valves for client cash pools, such as isolating non-performing assets within a portfolio or limits on daily redemption amounts. The FSB also proposed capital, leverage, liquidity, and asset concentration standards for non-bank lenders and mandatory risk sharing in securitization transactions.

But there are a number of unanswered questions from a global perspective and also from a Canadian perspective. Do the proposals for client cash pools go far enough, and should national governments consider a guarantee scheme similar to deposit insurance? Would mandatory risk sharing of securitization transactions cause investors to reduce their due diligence on those securities? Given the credit intermediation market in Canada, what constitutes shadow banking here? Credit unions are not regulated by OSFI, but they do have sub-national prudential regulation through provincial regulators. Would they be considered shadow banks?

The financial crisis demonstrated the systemic risk of the shadow banking system, and regulators are correct in responding. Let’s hope policymakers ensure their response comes with few unintended consequences.