Shadow banking is the super non-suspicious sounding practice of offering bank-like services without following banking regulations. This sounds kind of non-important at first, but chances are, they have affected your life more than you think. For example, shadow banks were a major factor in the great recession. If you have taken out a loan in China, most likely it was from a shadow bank.
To understand shadow banks, we need to understand how normal banks operate. A bank makes most of its profits through loans. When someone wants to take out a loan, they usually go to a bank. The bank will take the loan, along with many other loans and turn them into securities. The securities are bought by an investor, and in return, the investor will receive a portion of interest from the loan(s). But what happens when the loan is not paid off? This is where bank accounts come in. When you put your money in a bank account, the bank can use it for whatever they want. When someone can’t pay off the loan, the bank uses your money to pay for the losses they incur, returning your money when they get more profits. This system works well for everyone, the investors get a secure investment, you get a safe place to store your money, and loans stay cheap.
Shadow banks are different; unlike normal banks, shadow banks do not have banking licenses. The things shadow banks do are not usually illegal, but are still shady. Shadow banks usually don’t have bank accounts, so they have no way to pay their expenses if someone defaults on their loan. Shadow banks are just a middle man between investors and loan-takers. Since shadow banks have a significantly lower operating cost compared to conventional banks, they can offer loans with a much lower interest rate, and to much riskier clients. Shadow banks are thought to be a major factor in the 2007-2008 economy crash because of their lending of home loans to buyers who could not pay them off, causing an artificially high demand for housing.
In my opinion, shadow banks are the natural result of strict government regulations on investment; this is easiest to see in China. China has enormous regulations on what investments can, or cannot be made; for many Chinese citizens, shadow banks are the only reliable way to make an investment. The Chinese Communist Party also has nearly complete control over their banking sector, resulting in high operating costs for banks, thus high interest rates on loans. Things in the U.S.A are a little different. After the great recession, the U.S. removed many of the regulations that led to shady banking practices, but shadow banks are still around. There is a limit on how many bonds can be taken out from the U.S. treasury. Legitimate banks often have a limited selection of investment opportunities, due to their higher cost of operation. I think as more of the financial sector jobs become automated, the operation cost of banks will go down, and shadow banks will become less useful. On the other hand, investors will also become automated. Is this how things must be? Should we just wait until robots make banks cheap enough to put shadow banks out of business? Should we just lift the regulations on investment now to postpone the inevitable replacement of human labour by robots by a few more years? Now excuse me while I invest in that shady bank down the street, before the Chinese Communist Party takes it down with their robots!