Credit is one of the most critical factors in development and growth of the national and global economy. Innovation today is driven by new age companies and their execution is dependent on availability of credit to these entrepreneurs. Shadow banking is essentially unregulated or minimally regulated non-banks which are participants in the lending business. The characteristic feature which makes shadow banks a distinct entity from banks is that they have limited access to cheap public deposit and central banks i.e. Reserve Bank of India in the Indian context. Major non bank players are non-banking finance companies (NBFC’s), private equity and credit funds, mutual funds, peer to peer lenders and fintech. They are funded by other non-banks, high network individuals, banks, financial institutions like pension funds and insurance. This results in a 2%to 3% increase in cost of borrowing.
This high cost is partly offset by low cost of compliance and regulatory cost. The viability of this business model is majorly due to the inability of banks (on account of their risk metrics, regulatory restrictions, cost structure and limited reach) to lend money to various sectors that include but are not limited to real estate, micro-finance, small businesses, equity capital and start-ups. In India, ~30% lending is done by shadow banking which translates roughly to 60 lakh crore rupees. The size of this market is a testament to its value in the Indian economy. This value is magnified when banks are struggling to lend money due to internal policies and regulations. This being said, shadow banking does have systemic risk. Non-banks borrow majorly from banks and mutual-funds thus they indirectly borrow from the public. Hence if they face a downfall, it has the potential of having a contagion effect on the financial system.
This is mitigated in India by non banks being regulated by the Security Exchange Board of India (mutual funds) and Reserve Bank of India (NBFC’s). Regulatory supervision is done both directly as explained and lending by banks and mutual funds is regulated, albeit lesser than banks A prime example of this is the Deewan Housing (a NBFC which went insolvent) crisis in which proactive action from regulators minimized far-reaching systemic impact on the financial system. Another risk is the social perils that arise with accessibility to easy money, specially in a country like India having a young demographic profile.
To conclude, shadow banking is critical for the growth of the Indian economy as banks are not able to offer credit to various segments, sectors, purposes and geographies hence shadow banking by enabling availability of credit to these segments, sectors, purposes and geographies is not only helping the economy to grow but is also providing opportunity to entrepreneurs and creating employment.
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