Today we are going to learn what is the Shadow Banking,
While the name may sound like something secret or illegal, this is just a parallel system to the traditional banking system for lending to individuals and businesses. Nothing illegal
Let’s take an example to simplify the general explanation and understand how this system works, and probably you have used it without even thinking about it or knowing it. We use simple and easy numbers, purely for explanatory purposes.
Luca needs a loan to renovate his house, he goes to his bank and asks for an amount X. Luca is a good payer and therefore the bank would grant him the loan at a rate of 5% per year
However, Luca is not satisfied and remembers that a colleague suggested the CCX Finance. CCX deals with loans for real estate, cars, university and more.
Luca shows up in one of the CCX offices and the same loan for the same amount X would have a rate of 3.5%.
Luca as a customer does not find differences in the two loans, his only interest is in having the amount X he needs at the lowest available cost in the same agreed period of time.
So Luca for his convenience chooses to make a contract with the CCX
Here is an example of shadow banking.
The problem with shadow banking is how it is done or created. The banking circuit is created by people who save, and this savings goes into their current bank accounts. these current accounts are remunerated at 1%
the banks take this money, in customer accounts, and lend it to people like luca, at a rate of 5%. The difference between account yield and loan rate is the bank’s business
CCX, on the other hand, having 200 Luca accessing his loan service, transforms the series of loans made to its customers into a derivative financial product.
Inside there will be loans whose risk will vary, as people will be different and with a different financial history, from the safest to the most risky.
Obviously the greater risk will be more rewarded by customers with a worse financial history
This financial instrument will then be bought by someone, in this case from a pension fund, as its return on the market makes it extremely attractive.
the currency of the purchase of the instrument will enter into CCX, which will thus be able to create other loans to others Luca, loans which will be transformed into derivatives and sold to other funds and so on without stopping
As far as banks are concerned, there are strict regulations, especially after the 2008 crash. These regulations serve as a safety net for the banks and consequently for its customers.
Let’s talk about capitalization and specific rules to save your deposited money
In companies like CCX, on the other hand, there is no safety net or if there is, it is very thin given the low or almost no regulation
Over the various years, the percentage of loans disbursed by banks in relation to loans disbursed by shadow banking has increasingly been in favor of the latter.
The main risk arises in the creation of the derivative financial assets that have the debts inside. The economic situation could change to a worse one, These debts could become bad debt and therefore waste paper. The problem would spill over to those who are the holders of the derivative securities, which could go to a value equal to zero and therefore cause the funds that hold them to fail.
On the other side of the fence, in the event of a lack of financial stability, the funds interested in purchasing these derivatives could be scarce, putting companies like CCX in difficulty and causing their customers to return to the banking world for liquidity. necessary.