The trouble is that, by 2010, the shadow banking system was about the same size as it was just before the 2007 market crash, whereas the regulated global banking system was 18 larger than in 2007. That is why the FSB report pinpoints the shadow banking system, together with the large global banks, as sources of systemic risk.

The alternative theory of a global credit glut gained more ground with the release last week of the Financial Stability Board s report on shadow banking. The FSB report contains startling revelations about the scale of global shadow banking, which it defines as credit intermediation involving entities and activities outside the regular banking system.

The shadow banking system is estimated at roughly 25 30 of the global financial system ( 250 trillion, excluding derivatives) and at half of total global banking assets. This represents a huge regulatory black hole at the center of the global financial system, hitherto not closely monitored for monetary and financial stability purposes.

According to market sources, total assets managed by the shadow banking system have risen exponentially since 2009, totaling 14 trillion, or one third of GDP, in the third quarter of 2012. With relatively slow growth, corporate profitability, upon which the returns of the shadow banking system s asset pools are based, is low and falling.

At the very least, the combination of higher interest rates in the shadow banking sector and weaker nominal GDP growth undermines borrowers debt repayment capacity. In a worst case scenario, falling property prices or diminishing faith in implicit government guarantees would compound the risks generated by the shadow banking system, severely undermining China s financial stability.

Fourth, the financial system despite the policy backstop is severely damaged. Most of the shadow banking system has disappeared, and traditional commercial banks are saddled with trillions of dollars in expected losses on loans and securities while still being seriously undercapitalized.

Worse, restricting commercial banks role as financial intermediaries and encouraging the growth of unregulated shadow banking has generated even more risks for China s economy. Clearly, a new approach is needed one that is based on a deeper understanding of the dangers inherent in China s banking system.

the decision was made to eschew principles based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government s guarantee of the commercial banking system was enough to keep us out of trouble

And the regulatory boundary problem persists risky activities may migrate to areas where regulation is lax and reproduce the problems with the shadow banking system that we have witnessed during the crisis. As a result, investment banking operations might need to be rescued if they pose a systemic threat.

At the Jackson Hole conference, Paul McCulley of PIMCO, the world s largest bond fund, argued that in the past month or two we have been witnessing a run on what he calls the shadow banking system, which consists of all the levered investment conduits, vehicles and structures that have sprung up along with the housing boom. The shadow banking system, which is beyond the reach of bank regulators and deposit insurance, fed the boom in home prices by helping provide more credit to buyers.

Meanwhile, China s shadow banking system has expanded at an unprecedented rate. But here, too, mounting risks have been largely ignored, owing partly to the collateralization of real property, which is believed to retain its value permanently, and partly to the system of implicit government guarantees that backs loans to local governments and SOEs.

In 1988 the Basel Committee on Banking Supervision1 issued Prevention of the Criminal Use of the Banking System for the purpose of money laundering.

The Algerian banking system does not favour this method of payment and transfer.

Bond investors heavy reliance on credit rating agencies, which tend to be laxer with powerful issuers, has not been fixed. The shadow banking sector s dependence on the official banking sector s liquidity and guarantees, and thus ultimately on the government, has not even been touched.

If the shadow banking system collapses, the consequences for the financial system will be much graver than the problems caused by underground credit networks and local government finance platforms, which were much discussed in 2012. No wonder, then, that one influential banker regarded as a possible successor to PBOC Governor Zhou Xiaochuan has warned of the possibility of a Chinese style subprime crisis.

Given this, China s leaders must use a combination of financial sector reforms and improved public sector incentives to increase access to capital in sectors with high potential rates of return. In fact, this process is underway with the licensing of new private banks and the development of China s shadow banking system.

China s vulnerabilities and risks stemming from property bubbles, shadow banking, and local government debt have triggered concerns about a crisis not only there, but also in neighboring Asian countries. Some, indeed, now predict a Chinese banking or fiscal disaster others predict long term stagnation equivalent to Japan s lost decades.

So what you see is nothing but shadow of a shadow of a shadow.

The weak capacities of local implementing partners and lack of a banking system also constrain effective implementation.

The banking sector has undergone tremendous transformation, from over 80 banks to 25 banks. Strengthening of the system.

Second, with China such an influential driver of global demand (both directly and indirectly through important network effects), the outlook for the world s second largest economy has a disproportionate impact on projections of global corporate revenues. And, as China s excessive domestic credit growth and shadow banking system attract increased attention, many companies are becoming anxious.

On top of all this, there is a shadow financial system of non bank financial institutions that, like banks, borrow short and liquid and lend to or invest in longer term and illiquid assets. This shadow system includes structured investment vehicles (SIVs), conduits, money market funds, hedge funds, and investment banks.

Other terms include parallel banking, underground banking and ethnic banking.

But, to circumvent the restrictions in the state dominated financial system, a shadow banking system has developed, raising new risks economic distortions reliance on excess leverage to drive growth in the consumer, real estate, corporate, and government sectors and dangers associated with inadequate regulation. As a result, investors are worried that China could slip into the excess leverage growth model that has served many developed economies so poorly.

More important, financial repression is contributing to a widening disparity between state owned enterprises (SOEs) and small and medium size enterprises (SMEs), with the former enjoying artificially low interest rates from commercial banks and the latter forced to pay extremely high interest rates in the shadow banking system (or unable to access external financing at all).

But another Fed faction led by Governors Jeremy Stein and Daniel Tarullo argues that macro prudential tools are untested, and that limiting leverage in one part of the financial market simply drives liquidity elsewhere. Indeed, the Fed regulates only banks, so liquidity and leverage will migrate to the shadow banking system if banks are regulated more tightly.

BEIJING The US Federal Reserve s decision to exit from so called quantitative easing its massive monthly purchases of long term assets is stoking fears of a hard economic landing in China. But China s strong economic fundamentals mean that policymakers have the space to avoid such an outcome as long as they bring the country s shadow banking system under control.

Third, the interaction between the shadow banking system and the global banks is highly concentrated, because the global banks act as prime brokers, particularly for derivative trades. Data from the US Comptroller of Currency suggest that the top five US banks account for 96 of the total over the counter (OTC) derivative trades in the US.

There was also a commodity bubble and a private equity and hedge funds bubble. Indeed, we now see the demise of the shadow banking system, the complex of non bank financial institutions that looked like banks as they borrowed short term and in liquid ways, leveraged a lot, and invested in longer term and illiquid ways.

The reason is that healthy spending and production no longer depend only on the soundness of the banking system and public confidence in its stability. Nowadays, the banking system is much larger than the set of institutions formally called banks that are intensively regulated by central banks and treasuries.

First, it does not do enough to shield retail banking from investment banking risks, of which only a small share relate to proprietary trading. Second, the US has a very different banking system to begin with, including various regulations on how depository institutions can relate to affiliated trading entities.

The losses incurred by domestic investors can have a long term effect on the pension system or the banking sector.

As a result, a credibility deficit has developed, which casts a shadow on the reputation of the United Nations system as a whole.

The PBOC frequently does this by selling bonds to commercial banks or raising their reserve requirements. But this has reduced these banks effectiveness as financial intermediaries, while encouraging the rise of shadow banking to circumvent the restrictions.

With the defeat of the Scottish referendum, it is clear that the UK will still have a single integrated banking and financial system for the foreseeable future. In the US, which similarly has an integrated banking system, the federal government steps in when banks in a state are in serious trouble.

Since much of the money market funds assets are IOUs from the world s biggest banks, the withdrawals weakened the already shaky global banking system. The Federal Reserve, seeking to stem the growing panic and stabilize the American and international banking system, promptly guaranteed the value of all money market funds.

Shadow saturation

In 2011 and early 2012, there was much talk of a crash in China s housing market, and a chain reaction of defaults in underground credit networks and local government finance platforms. In 2013, the talk has changed to the danger of a resurgent housing bubble and the collapse of the shadow banking system, which consists mainly of wealth management firms and trust companies.

The report, which was requested by G 20 leaders at their summit in Seoul last November, found that between 2002 and 2007, the shadow banking system increased by 33 trillion, more than doubling in asset size from 27 trillion to 60 trillion. This is 8.5 times higher than the total US current account deficit of 3.9 trillion during the same period.

Similarly, inefficient state banks far inferior to private banks even in Kazakhstan or Ukraine dominate the banking system. The not very profitable state owned Vneshtorgbank, for example, is on a buying spree, aggravating the quality of Russian banking.

In traditional economic models, increased liquidity results in more lending, mostly to investors and sometimes to consumers, thereby increasing demand and employment. But consider a case like Spain, where so much money has fled the banking system 160 and continues to flee as Europe fiddles over the implementation of a common banking system.

In traditional economic models, increased liquidity results in more lending, mostly to investors and sometimes to consumers, thereby increasing demand and employment. But consider a case like Spain, where so much money has fled the banking system and continues to flee as Europe fiddles over the implementation of a common banking system.

The banks these banks are now consolidated, and that strengthening of the banking system has attracted a lot of investment from outside.

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The Shadow dialog