Shadow Banking And Monetary Policy

The Bank of England just published a research paper “Do contractionary monetary policy shocks expand shadow banking?”

We previously discussed the role and importance of shadow banking, making the point that up to the 1980s, traditional banks were the dominant institutions in intermediating funds between savers and borrowers. However, since then, the role of market-based intermediaries has steadily increased. Whilst shadow banking cannot be defined as a homogenous, well-defined category, it embrances at least three types of intermediaries: asset-backed (ABS) issuers, finance companies, and funding corporations. In addition, shadow banking sector involves a web of financial institutions and a range of securitisation and funding techniques, and these activities are often closely intertwined with the traditional banking and insurance institutions. These interlinkages can involve back-up lines of credit, implicit guarantees to special purpose vehicles and asset management subsidiaries. So, given the focus on greater banking system regulation, and the role of monetary policy in this, the question is, does tighter monetary policy flow on to impact shadow banking. Is so, how?

Using detailed modelling, they find that monetary policy shocks do seem to affect the balance sheets of both commercial banks and their unregulated counterparts in the shadow banking sector. However, a monetary contraction aimed at reducing the asset growth of commercial banks would tend to cause a migration of activity beyond the regulatory perimeter to the shadow banking sector. In fact the monetary response needed to lean against shadow bank asset growth is of opposite to that needed to lean against commercial bank asset growth.

This means that monetary policy designed to control commercial banking may, as an unintended consequence, increase shadow banking activity (and so work against the policy intent). Therefore, they suggest that authorities should continue to develop a set of regulatory tools, complementary to monetary policy, that (a) seek to moderate excessive swings in risk-taking by commercial banks, as embodied in recent macroprudential frameworks, and (b) seek to strengthen oversight and regulation of the shadow banking sector. Monetary policy alone is not enough.

Author: Martin North

Martin North is the Principal of Digital Finance Analytics

Leave a Reply