Off The Grid: A Detailed Investigation Behind the Shadow Banking in Developing Countries

Kaushik Sankar '28

Bank heist movies have given us a glimpse into the elaborate security systems that guard money, from massive steel vaults to intricate laser grids. Beyond just protecting money, this security symbolizes the structured and regulated access to financial resources that formal banking provides. The Federal Deposit Insurance Corporation provides deposit insurance for cash held at commercial banks, including savings and checking accounts, certificates of deposits, and money market deposit accounts. Knowing that our money is secure is a privilege we often take for granted. Yet, this begs the question: what financial activities exist outside this regulated realm? The answer lies in shadow banking.

Shadow banking describes bank-like activities (mainly lending) without oversight, including credit transformation (transferring loan default risk to investors), liquidity transformation (using cash-like liabilities to buy assets), and maturity transformation (using short-term funds to invest in long-term assets). Some common examples include hedge funds, investment banks, and private equity funds. Shadow banks have the potential to destabilize entire financial systems, as seen in the 2007 global economic crisis, yet they hold roughly $63 trillion, accounting for 78% of global GDP. Shadow banking is also growing in many developing countries, such as East Asia, driven by various factors and operating in multiple methods.

As of 2021, the World Bank estimated that 1.4 billion adults worldwide lacked access to a bank account. While significant progress has been made in improving financial inclusion, a staggering number of people have yet to be included in formal banking systems. Shadow banking, in the form of finance companies and microcredit lenders, tends to provide credit to communities that are underbanked and low-rated firms in developing countries.

Shadow banking is prevalent in China, as it has the highest growth rate of shadow banking, and examining it offers valuable insights into broader patterns regarding shadow banking’s presence in developing countries.

Many Chinese banks don’t offer credit to SMEs or small and medium-sized enterprises, mainly because bank-loan profits from SMEs are less attractive, and banks are reluctant to take on the higher risks of this lending. As a result, many SMEs look to the shadow banking sector as an alternative, specifically interpersonal lending options like credit associations, rural cooperative foundations, and even pawn shops.

This reveals the idea that shadow banking serves as a last resort when formal institutions aren’t accessible, which is analogous to systems in various other developing countries. In India, loan sharks thrive as India has a large population with many people having no credit history and desperate for access to credit, which loan sharks lend at a very high rate. This is especially true in rural areas where money lending has been a practice for decades, and loanees don’t have access to state-owned banks, pushing many to the point of suicide (example). In rural India, the presence of loan sharks is often a result of limited access to regulated financial institutions. However, even in rural areas, shadow banking can have positive effects. This is seen in the communal model of chamas in Kenya, where a group of 15-30 pool money every week or month, offer low-interest loans to members, and invest in a collective asset (such as land). The Chama system helped many smaller retailers in the 1990s deal with rising prices due to the liberalization of the economy.

While shadow banking can have specific positive effects, the rise of shadow banking in China’s property sector reflects why it needs to be dealt with cautiously. According to CNBC, Chinese real estate companies bought land from local governments that needed the economic benefits of regional development. People flocked to buy homes since prices rose over the past two decades. To purchase the land, developers borrowed heavily from shadow banks, which led to a rise in the price of land and high housing costs. Later, in 2020, Beijing set limits on debt levels to limit developers. Since there is no system of governmental regulation, shadow banks can increase the risk of financial instability and economic setbacks and exacerbate economic vulnerabilities more rapidly than in developed countries.

Since many countries rely heavily on shadow banks as a way to access credit, they have the potential to hinder this access as there are many layers between the lender and the final borrower. Shadow banking has resulted in a complex credit chain with too many intermediaries, raising borrowing costs and limiting access to capital. Though shadow banks play a role in efficiently spreading credit, the growing number of layers, now averaging 2.3 intermediaries per investment, can increase financial risks and instability.

While shadow banking carries negative connotations, it plays an instrumental role in uplifting people of developed economies and providing them access to credit as an alternative to regulated financial institutions. Yet, it is essential to mitigate this influence to ensure stability.