Research & Analysis

Inclusive Finance and Shadow Banking

The term “shadow banking” came into widespread usage with the onset of the global financial crisis to refer to a broad array of entities and activities operating outside the regular banking system that were being used to perform bank-like functions. The Financial Stability Board (FSB) defines the “shadow banking sector” in the broadest sense as “credit intermediation involving entities and activities outside the regular banking system” (FSB 2011).

Credit intermediation—or borrowing from one source to make loans to another—is a core element of banking. Banking regulation and supervision are designed to control credit intermediation and maximize the likelihood that banks can repay their creditors, especially retail depositors. Credit intermediation by nonbanks potentially raises two problems. First, depending on the regulatory system, such intermediation may take place without the prudential regulation and supervision required of a bank (i.e., outside the “supervisory perimeter”). If the aggregate level of such credit intermediation is significant in a given country, accumulated losses among nonbanks could affect confidence in the banking sector as well, particularly if the general public doesn’t understand which institutions are supervised and which are not. Second, nonbank credit intermediation can affect the stability of the banking sector when there are significant market interconnections between banks and nonbanks, which can increase the likelihood of ripple effects across institutions.

On its face, the broad definition of shadow banking would sweep in most microfinance, as well as some of the innovation by nonbanks in digital finance heralded by the G20 as fundamental to reach excluded and underserved households and businesses and thus advance financial inclusion. At the same time, since the global financial crisis of 2008–2009, the G20 has called for monitoring and reining in those shadow banking practices that helped trigger the crisis. Are these calls contradictory? Not at all—at least not yet. The destabilizing innovations of nonbanks in the period leading up to the financial crisis, such as increasingly complex derivatives, are absent from the inclusive finance landscape. While the very prevalence of nonbank actors, and the many “bank-like” activities in inclusive finance, may appear to trigger shadow banking concerns, the types of credit intermediation currently going on outside the watchful eye of banking supervisors appear to be different from the destabilizing activities that contributed to the financial crisis.

Yet with progress on financial inclusion—and ongoing innovation, sometimes reaching vast scale quickly—it is worth remembering that the very concept of shadow banking emanated from fast-changing market practices and a corresponding failure of financial regulation and supervision to keep pace. This Brief explains why approaches to inclusive finance that are currently widespread do not share the potentially destabilizing attributes of other types of shadow banking, concluding by identifying some risks worth monitoring as the picture continues to evolve.