When the credit crisis started in 2007, it soon became clear that many vulnerabilities had built up outside the view of the financial authorities. Assets that were deemed safe turned out to be risky and the size and distribution of risks were unclear. The process of credit intermediation had become fragmented across various jurisdictions and had largely shifted to non-bank players, also referred to as the shadow banking sector.
What is shadow banking?
Shadow banking means that financial intermediation is performed differently from traditional banks and largely carried out by non-banks. These institutions jointly form an intermediation chain in which credit, maturity and liquidity transformation take place. The shadow banking sector has strong interaction with banks and institutional investors. Banks usually act as the supplier (originator) of loans to the public. These loans are then securitised, while institutional investors are important holders of the securitised products. As a result, illiquid claims are converted into negotiable securities while specific products can be developed which match ultimate investors’ desired risk profile and liabilities.
Shadow banking offers various advantages. Institutions primarily focus on a single part of the intermediation process, which creates opportunities for specialisation and economies of scale. For instance, firms may exclusively focus on originating loans or the development of financial instruments based on credit. In addition, concentration risk can be reduced by spreading exposures across several parties.
But as has become evident over the past few years, this also gives rise to new risks. The financial system has become less transparent as a result of the increased complexity and the large number of parties and jurisdictions involved. Besides, shadow banks are often not supervised or only indirectly as part of a financial group. Due to the limited supervision and the absence of safety nets, possibilities for intervention are constrained. Moreover, the shadow banking sector has long facilitated imbalances, such as the excessive accumulation of excessive debt in the financial system. Due to securitisation, credit risks disappear from banks’ balance sheets, allowing them to grant more loans.
The size of the shadow banking sector is hard to establish exactly. It is not organised along national or sectoral boundaries and it is constantly changing. At the same time, many shadow banking entities do not have to report to the authorities. Also, only part of the activities of many institutions qualifies as shadow banking. The Financial Stability Board (FSB) uses a broad measure for shadow banking institutions, namely all 'other financial institutions', i.e. all institutions apart from banks, insurers and pension funds. The FSB deliberately casts its net so wide to set an upper limit on the shadow banking sector. Prior to the crisis, the balance sheet total of other financial institutions worldwide had doubled to approximately USD 60 trillion. Since 2007 this growth has stalled and in particular securitisation activities and money market funds have decreased in size.
With a balance sheet total of some EUR 3,000 billion, the Netherlands has the third largest sector of 'other financial institutions' in the world, after the United States and the United Kingdom. According to the FSB's broad measure, the Netherlands therefore takes up a prominent position. As the FSB points out, however, it is important to perform in-depth analyses to define shadow banking entities and activities more precisely. Such further research by DNB has shown that especially securitisation vehicles, finance companies and part of the special financial institutions (SFIs) can be considered elements of the Dutch shadow banking sector (Chart 1). Money market funds and hedge funds also have shadow banking characteristics, but they play only a marginal role in the Netherlands.