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This concept of OFIs seemed consistent with the FSB’s broader definition of shadow banking.

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This concept of OFIs seemed consistent with the FSB’s broader definition of shadow banking. However, there had to be a separate quantification associated with the FSB’s narrower definition. And indeed, in its 2015 Global Shadow Bank Monitoring Report, the FSB published an “economic functions approach” to identifying shadow banking activities, which classified those types of financial activities that fulfilled the narrow definition.13 Reddy made note of these economic functions, their descriptions, and their typical entity types (Exhibit 3). Additionally, she reviewed data breaking down the share of shadow banking assets by economic function (Exhibit 4), along with the growth in shadow banking consistent with the narrower scope (Exhibit 5), and the distribution of worldwide financial assets among banks, OFIs, and shadow banks (Exhibit 6). Unfortunately, the FSB could only trace data for the narrow measure back to 2010. Nevertheless, the data seemed to run counter to some of the commonly held beliefs about shadow banking. Trends in the United States may have influenced the landscape because the United States maintained by far the largest share of global shadow banking assets (Exhibit 7). After the GFC, however, one of the most significant drivers of shadow banking growth—U.S. consumer credit—stalled significantly (Exhibit 8). Conversely, China’s share of worldwide shadow banking assets had grown markedly (Exhibit 7). In fact, Reddy had reason to believe the FSB’s data underrepresented shadow banking activity in China. Due to a definitional discrepancy, China’s FSB shadow banking data represented purely OFIs.14 Meanwhile, Reddy knew that Chinese shadow banking was linked primarily to banks engaging in off–balance sheet activities. Specifically, a large portion of shadow banking activity had been generated by banks or trust companies offering wealth-management products (WMPs) to yield-starved investors and lending directly to small and medium enterprises (SMEs) or entrepreneurs, who might not otherwise fit state-mandated lending requirements.15 Chinese OFIs, therefore, did not capture the full shadow banking landscape.

The FSB’s data was a start in understanding the scope of and trends in the shadow banking sector, but Reddy was well aware that one of the big challenges in this arena revolved around data reliability. Many of the institutions that operated in this space did not have regulatory or public company reporting requirements. In fact, a Federal Reserve official had conceded that regulators’ “view of developments” in “the shadow banking sector—remains incomplete.”16 In any case, Reddy believed she had a decent grasp on the general nature of the shadow banking industry. Now, she wanted to more fully examine the typical business model the industry pursued.

The Business Model17

To understand the shadow banking business model, Reddy thought it wise to revisit the nature of traditional banking. At the most basic level, traditional banks intermediated between individual lenders and borrowers. Individuals typically could not lend directly to borrowers due to liquidity, timing, and informational constraints. The bank filled this gap by pooling deposits, of which they only needed to keep a fraction on hand, and seeking to find creditworthy borrowers who could put the funds to productive use. In this manner, banks engaged in

13 14 The FSB noted in its monitoring report that China disagreed with the characterization of shadow banking activities, and, therefore, its shadow

banking data was purely a reflection of its OFI activity. 15 Wei Jiang, “The Future of Shadow Banking in China,” Columbia Business School: Jerome A. Chazen Institute of International Business, 2015, (accessed May 15, 2016).

16 Stanley Fischer, “Financial Stability and Shadow Banks: What We Don’t Know Could Hurt Us,” speech at the 2015 Financial Stability Conference, December 3, 2015, (accessed May 16, 2016).

17 Unless otherwise noted, concepts in this section are derived from shadow-banking-really-banking.

For the exclusive use of s. kapoor, 2018.

This document is authorized for use only by shivam kapoor in FIN315 Fall2018 taught by Victor Jarosiewicz, Bryant University from Nov 2018 to Dec 2018.