The need for regulation in the money market is inevitable,and thus the traditional money market trade- characterized by deposits and loans is ever under the regulation of the government through central banks and other regulatory bodies. Shadow banking, which constitutes lending and borrowing taking place outside the deposit and loan model provides a more comfortable way around the money market making it possible for lenders and borrowers to exchange resources without necessarily having to go through the hassle of regulatory procedures. This practice has both a good and evil side comprising its advantages and disadvantages as may be seen through studies of its effects on economies that have at one time or the other been succumbed to its influence.
To start with the pros, as mentioned above, shadow banking makes it possible for financial institutes to increase their return on investment by providing funds to borrowers through loans that are off the balance sheet. This may be done through venture capital, private equity, hedge funds and wealth management vehicles. As compared to conventional bank deposits, shadow banking instruments have a potential for yielding higher returns and their ease in availing funds to those in need of loans needs not to be mentioned.
Such factors make shadow banking a seemingly reasonableway of solving economic funds imbalances to its cons are considered. The risk is inherently attached to insecure lending mark the first disadvantage of shadow banking. In the Chinese case,for example, the assets and ventures invested in by buyers of shadow banking loan items lack in perspective for generating enough revenue to settle the debts. The first consequence of the resulting situation is a more great risk of driving an economy into a liquidity crisis. As was the case in the US, shadow banking also has the potential for yielding unsustainable real estate bubbles and unfit inflation rates. The worst case scenario takes place when the demand for loans falls,andthe financial institutions no longer have a source of liquid funds,and then financial crisis erupts.
For this reason, it is advisable for China to cub if not entirely eliminate shadow banking. Given the kind of investments that China’s economy is built upon, infrastructure construction and exports, insecure lending poses a higher risk to the state. This is so because both economic activities highly depend on trends in the global economy and notably also have diminishing prospective for yielding returns over time. The low prices of labour in China and the restrictions around the growth of the same also make issuance of deregulated loans in such a nation riskier.
If the flexibility of labour prices and its ability to affect the risks inherent to shadow banking is the only factor to consider, then the question as to why shadow banking should be burned in the United States of America would automatically be no. There are however other factors to consider. The resulting imbalance between demand and supply for items financed by the shadow lending items such as the real estate is one such factor that renders shadow banking a bad option for the US as well. The result of such an imbalance would be lowered prices of the investments in question thus the risk of high rates of loan forfeitures and since the loans were neither secured nor supported by the government losses and national financial crisis would occur. Worse still given that American investors have the liberty to invest in other nations, the global economic crisis might also burst forth. As such, shadow banking remains a no go zone for both China and the US and for any other economy that cares for its long term performance and stability as opposed to temporary economic bubbling.