There is a legitimate controversy (that I will not dwell on here) on both the definition of "shadow banking" and the size of the global shadow banking system that should be measured. Let me go by the current gold standard, the Financial Stability Board's estimate, that pegs it about (hold your breath) $74 trillion or about 117 per cent of global gross domestic product in 2012. This marks the geographical diversity of its growth - the emerging world saw growth of 20 per cent in 2012, while Spain, to take an example from the crisis-affected developing world, saw a decline of 12 per cent. The growth rate of China's shadow banks was 32 per cent
Many economists argue that the forms of shadow banking are so diverse that the current literature on its regulation (that tends to be largely US-centric) has little relevance. It is difficult to disagree with this entirely but a couple of things need to be borne in mind. First, financial instruments and structures similar to the US are slowly evolving in India. I would take the case of money market mutual funds and their increasing role in disintermediation - companies issuing short-term debt (commercial paper) instead of borrowing from banks. Let me make a quick qualification. We are nowhere near the complexity or borrowing levels that the US saw when its financial system imploded. However, it is good to keep in mind the tribulations of the US in our regulatory approach to these structures.
In fact, the use of the word "shadow banking" somehow suggests that there are sinister things afoot in that murky world. That would be an overreaction. Shadow banks are not always the result of an effort by greedy bankers to dodge the regulator (regulatory arbitrage) but a response to a genuine economic demand. Securitisation, sans the manic financial engineering that characterised the US markets of the first half of the last decade, can actually be a good thing. For one thing, it frees banks from the need to hold capital against assets. In the world of Basel-III norms, where banks' capital needs are multiplying and in the absence of any depth in the corporate debt market in India, more securitisation may be one of the few ways to meet the cash needs of critical projects in infrastructure and housing. Let's not throw the baby out with the bathwater.
The copious discussion among economists (which has predictably led to a lack of consensus) has essentially produced three possible approaches to shadow bank regulation. The first can be broadly referred to as convergence that suggests that shadow banks be merged into the conventional banking system and the regulatory remit of the banking regulator to oversee these functions be expanded. The second calls for ring-fencing of core banking activities (say, retail operations as Lord John Vickers of the UK has proposed) from the shadow banks that could be regulated with the proverbial light touch. The third is to create specialised financial structures - "narrow" savings and loan banks, for instance, that focus on a particular product like, say, securitised assets and become the sole intermediary between all issuers and investors. None of these are the proverbial silver bullet. Ring-fencing banks will no doubt lead to greater safety for banks but it does not mitigate the risks that the sheer size of the "shadow system" poses for the larger economy. Convergence leads to greater instability for the banking system since shadow bank activity tends to be more procyclical.
The variety in India's shadow financial system parallels of the ecosystem of the Amazon rain forests. You have Nidhis, chit funds, para-banks, plantation companies - the list is endless. These have to be regulated better because even if they do not pose a risk to the economy as a whole, their capacity for causing local distress is enormous (remember the Saradha scam?). However, conventionally the non-banking financial companies (NBFCs) have been considered or "shadow banks" and regulators have focused on the so-called systemically important ones. The key risk is not so much that some of them take public deposits (this is minuscule) but because of their dependence on bank finance both directly and directly through bond and debenture issues. While new regulations have tried to bring some of their regulatory standards on a par with banks and ensure that they always have enough liquid assets, let's not forget the fact that there was a crisis in our shadow system pretty much at the same time as the blowout in the US. The big controversy these days is over who should regulate the NBFCs. The Financial Sector Legislative Reforms Commission has said they (the non-deposit taking ones) come under the umbrella of a super-regulator. The question that needs to be answered is - given their close links with the banks, isn't it better for the banking regulator, the Reserve Bank of India, to regulate both?
The writer is an independent economist. These views are personal