103208 BRIEF Inclusive Finance and Shadow Banking: Worlds Apart or Worlds Converging? “Financial stability is more likely to be jeopardized by…the rise of ‘shadow banking’ as a result of the withdrawal of consumers from regulated banking than from inclusion efforts.” Dr. Zeti Akhtar Aziz Governor, Bank Negara Malaysia AFI/G24 Forum, Washington, D.C., April 2013 The term “shadow banking” came into widespread called for monitoring and reining in those shadow usage with the onset of the global financial crisis banking practices that helped trigger the crisis. Are to refer to a broad array of entities and activities these calls contradictory? Not at all—at least not operating outside the regular banking system that yet. The destabilizing innovations of nonbanks in were being used to perform bank-like functions.1 The the period leading up to the financial crisis, such as Financial Stability Board (FSB) defines the “shadow increasingly complex derivatives, are absent from the banking sector” in the broadest sense as “credit inclusive finance landscape. While the very prevalence intermediation involving entities and activities outside of nonbank actors, and the many “bank-like” activities the regular banking system” (FSB 2011). in inclusive finance, may appear to trigger shadow banking concerns, the types of credit intermediation Credit intermediation—or borrowing from one currently going on outside the watchful eye of banking source to make loans to another—is a core element supervisors appear to be different from the destabilizing of banking. Banking regulation and supervision are activities that contributed to the financial crisis. designed to control credit intermediation and maximize the likelihood that banks can repay their creditors, Yet with progress on financial inclusion—and ongoing especially retail depositors. Credit intermediation innovation, sometimes reaching vast scale quickly— by nonbanks potentially raises two problems. it is worth remembering that the very concept of First, depending on the regulatory system, such shadow banking emanated from fast-changing market intermediation may take place without the prudential practices and a corresponding failure of financial regulation and supervision required of a bank (i.e., regulation and supervision to keep pace. This Brief outside the “supervisory perimeter”). If the aggregate explains why approaches to inclusive finance that are level of such credit intermediation is significant in a currently widespread do not share the potentially given country, accumulated losses among nonbanks destabilizing attributes of other types of shadow could affect confidence in the banking sector as well, banking, concluding by identifying some risks worth particularly if the general public doesn’t understand monitoring as the picture continues to evolve. which institutions are supervised and which are not. Second, nonbank credit intermediation can affect What Are the Attendant the stability of the banking sector when there are Risks of Shadow Banking? significant market interconnections between banks and nonbanks, which can increase the likelihood of Recognizing that a broad definition of shadow ripple effects across institutions. banking dilutes the intended focus on nonbank credit intermediation that destabilizes the financial sector, On its face, the broad definition of shadow banking FSB has highlighted several aspects of nonbank credit would sweep in most microfinance, as well as some of intermediation that can make it destabilizing: the innovation by nonbanks in digital finance heralded by the G20 as fundamental to reach excluded and • Maturity transformation is the activity of issuing underserved households and businesses and thus short-term liabilities (such as demand deposits) and advance financial inclusion.2 At the same time, since transforming them into longer-term assets (such as the global financial crisis of 2008–2009, the G20 has mortgage loans). 1 As used in this Brief, the term “shadow banking” is not intended to cast in a necessarily negative light all types of credit intermediation to which this term is sometimes applied (FSB 2013). The Financial Stability Board acknowledges that when conducted properly, intermediating credit through nonbank channels can have important advantages and contributes to the financing of the real economy (FSB 2011, 2013, 2014). September 2015 2 See, e.g., “Leaders Statement. The Pittsburg Summit.” 2009. 2 • Liquidity transformation is a concept similar to institutions also engaged in longer-term lending, such maturity transformation that entails using liquid as housing finance, or investment. liabilities (such as cash or digital value) to buy less liquid assets such as loans. Does this mean that nonbank institutions that issue • Opportunities to create or facilitate leverage. Leverage exclusively short-term microcredit cannot adversely is a general term referring to any technique to multiply affect systemic stability? Not necessarily. For example, gains (but also potentially losses), such as borrowing to banks may have incentives to fund such institutions, or finance lending or other investment activity. even create them, to evade regulatory restrictions on • Opportunities for regulatory arbitrage, which their own direct microlending activity—i.e., regulatory occur when firms tailor their behavior to qualify arbitrage, as in the case of Morocco (Lyman and Reille for lighter regulation and supervision or to evade 2005, Chehade and Nègre 2013) and Russia, for example, regulation and supervision altogether.3 where microlending institutions are not subject to the same interest rate regulation as banks themselves,4 or Focusing on these aspects helps to understand the because of priority-sector lending targets (as in the case real risks of shadow banking (see FSB 2011; IMF 2013) of India [CGAP 2010]). While bank lending is subject to and how they might intersect with inclusive finance. prudential regulation and supervision, risks to stability may lie in the perception of the nonbanks funded as “leveraged financial intermediaries with liabilities similar Nonbanks in Inclusive Finance— to bank-like deposits, i.e. liabilities that are perceived as Are They Destabilizing redeemable at par.” 5 Though many other factors were “Shadow Banks”? at work, market-specific “microcredit crises” in both Morocco and India suggest that the incentives for the Many institutions delivering financial services to banks can be so great—and the credit risk management the financially excluded and underserved—such as of the nonbank microcredit institutions so poor—as to microfinance and microcredit institutions, financial overwhelm the supervisor and risk triggering broader cooperatives, and issuers and distributors of e-money in instability in the banking sector (CGAP 2010; Chen, digital finance models (e.g., mobile network operators)— Rasmussen, and Reille 2010). are not licensed as banks (BCBS 2015). For many of the reasons explored below, the activities of these nonbanks Digital Financial Services Models do not trigger destabilizing shadow banking concerns. Another increasingly significant phenomenon in inclusive finance where nonbanks play key roles Microcredit Portfolios is digital financial services that target the mass Microcredits—short-term loans in small amounts to market, including the unserved and underserved.6 unserved or underserved households and businesses— While models vary widely—and with them the roles lie at the heart of many people’s concept of inclusive played by nonbanks—the essential feature is a digital finance. The wide array of institutions making such transactional platform that combines the functionality loans are typically funded diversely depending on the of a payment instrument with the value storage market and regulatory system, including by private functionality of a transaction account (see Lauer or public equity, deposits or deposit-like loans from and Lyman 2015). Once in place, additional financial individuals, loans from banks and other institutional services—credit, interest-bearing savings, insurance, lenders, and retained earnings. Regardless of the even investment products—can be offered to these composition of their funding base, however, maturity same customers via the digital transactional platform. and liquidity transformations are rare because microcredit is, by definition, short term. Of course this Currently the vast majority of digital transactional risk can arise, however, if the microcredits are made by platforms do not involve credit intermediation by 3 FSB (2011) also flags what it refers to as “flawed credit risk transfer.” As the credit risk transfers in question during the financial crisis are not of a type seen in inclusive finance, this Brief does not consider them. 4 In Morocco, bank refinancing of microfinance institutions not subject to interest caps (Lyman and Reille 2005) helped spur radical growth of the microlending sector in the mid-2000s and triggered a crisis that was brought under control in part through central bank intervention (Chehade and Nègre 2013). In Russia, since November 2014 the central bank has been publishing interest rates limitations on consumer loans as required by the Consumer Credit Law, but it does so for each type of financial service provider, in addition to the type of loan. This has resulted in a situation where a similar loan product could be priced widely differently depending on a provider’s legal form. Several prominent commercial banks have set up microlending subsidiaries, presumably to be free to charge higher rates on consumer loans than the banks themselves could charge (http://www.kommersant.ru/doc/2206320). 5 See http://ftalphaville.ft.com/2014/11/10/2036962/the-shadow-banking-system-define-it-before-you-size-it/ 6 As of 2013, mobile money accounts alone have been launched in more than 80 countries (GSMA 2014). 3 nonbanks: even nonbank issuers of digitally stored or represent regulatory arbitrage, regulators should value are typically required to hold customer funds in assess them through the lens of their underlying prudentially regulated and supervised banks or other economic functions or activities8 rather than legal safe and liquid investments (see Tarazi and Breloff names or forms (FSB 2013). In the inclusive finance 2010). Moreover, for the time being at least, additional world, the following two functions deserve attention financial services beyond payments and value storage as potential risk fronts to watch: offered via digital transactional platforms involve a prudentially licensed and supervised provider.7 • Base-of-the-pyramid (BoP) providers acting as collective investment vehicles with features However, even if current practices do not meet any of the that make them susceptible to runs. These can criteria flagged by FSB as characteristic of destabilizing include financial cooperatives accepting savings, shadow banking, potential for destabilization still exists. microfinance and microcredit organizations For example, in some markets unsupervised nonbanks— allowed to accept deposits or loans and regulated such as mobile network operators—often act as issuers differently than bank deposits, and nonbank issuers of deposit-like stored-value products, and the growth of e-money, though in most markets the current of this phenomenon has been so fast that the effect scale of any such activities is unlikely to be systemic. of their possible failure on consumer behavior cannot • BoP lenders dependent on short-term funding. easily be predicted. Systemically significant refinancing of microcredit or other BoP credit portfolios by banks (in particular, Monitoring the Inclusive if the banks use these lenders as a way to bypass Finance Landscape through regulation and supervision) and nonbanks (especially a Shadow Banking Lens if these nonbanks can act as collective investment vehicles) can potentially have a destabilizing effect The landscape of inclusive finance is evolving rapidly— that may be further exacerbated if microlenders are and particularly in the digital arena where the change allowed to issue longer-term loan and investment in scale can be rapid and dramatic. While current products in addition to microcredit, thereby innovations holding the promise of reaching unserved increasing maturity and liquidity transformation risks. and underserved customers sustainably and affordably Innovations in inclusive finance can include models thus far generally do not involve the kinds of maturity combining the above functions, such as peer-to-peer and liquidity transformation that helped to trigger (P2P) online lending platforms, which in countries like the financial crisis, incentives for regulatory arbitrage China have reached important scale.9 in inclusive finance abound, as in finance generally. FSB counsels regulators and supervisors to monitor Finally, while credit intermediation by microlending the trends in the shadow banking sector “to address institutions may not raise direct financial stability bank-like risks to financial stability emerging outside the concerns, rapid changes in the BoP credit—such regular banking system while not inhibiting sustainable as blurring of the lines among high interest, high non-bank financing models that do not pose such risks.” write-off consumer lending, and socially oriented The approach should be proportionate and focus on the microlending in some countries—are bringing about activities that are material to the system: FSB suggests consumer protection challenges that may threaten assessing the trends in the shadow banking sectors in financial stability indirectly, such as where consumer terms of the size and growth rates “both in absolute discontent and distrust in microlenders spill over to terms and in relation to the total debt, GDP, and the the broader financial sector (BFA and RMC 2014). size of the regular banking system” (FSB 2011). These and other potential risk fronts must also be To determine whether nonbanks are involved in viewed in perspective—and with due attention to shadow banking activities that may pose systemic risks the consequences of ongoing financial exclusion 7 For example, the M-Shwari interest-bearing savings accounts and consumer loans offered to customers of the M-PESA digital transactional platform of Kenyan mobile network operator Safaricom are the products of the Commercial Bank of Africa. See http://www.cgap.org/photos- videos/m-shwari-empowering-kenyans-financial-services 8 The five economic functions suggested by FSB to assess nonbanks’ involvement in shadow banking include (i) management of collective investment vehicles with features that make them susceptible to runs; (ii) loan provision that depends on short-term funding; (iii) intermediation of market activities that depends on short-term funding or on secured funding of client assets; (iv) facilitation of credit creation; and (v) securitization-based credit intermediation and funding of financial entities (FSB 2013). 9 See, e.g., Financial Times (2015). P2P services represent a distinct type of intermediation beyond the supervisory perimeter and raise many prudential and market conduct regulatory and supervisory issues beyond the scope of this Brief. September 2015 (including its adverse ramifications for systemic ———. 2014. “Global Shadow Banking Monitoring Report.” All CGAP publications Basel: FSB, October. http://www.financialstabilityboard.org/ are available on the stability, as yet little studied) (GPFI 2011).10 Here wp-content/uploads/r_141030.pdf CGAP Web site at again a call by the G20 merits mention: global policy www.cgap.org. makers are encouraged “to explore the linkages ———. 2015. “Seventh Meeting of the Financial Stability among financial inclusion, financial stability, financial Board Regional Consultative Group for Sub-Saharan Africa.” CGAP integrity and financial consumer protection” (G20 Press-release, 11 March. http://www.financialstabilityboard. 1818 H Street, NW org/wp-content/uploads/FSB-RCG-SSA-Press-release-2015- MSN P3-300 2012). 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Safaricom Limited FY2014 Results Vulnerabilities-in-Microfinance-Feb-2010.pdf Presentation. http://www.safaricom.co.ke/images/Downloads/ Resources_Downloads/FY_2014_Results_Presentation.pdf FSB (Financial Stability Board). 2011. “Shadow Banking: Scoping the Issues—A Background Note of the Financial Stability Tarazi, Michael, and Paul Breloff. 2010. “Nonbank E-Money Board.” Basel: FSB, April. http://www.financialstabilityboard. Issuers: Regulatory Approaches to Protecting Customer org/wp-content/uploads/r_110412a.pdf Funds.” Focus Note 63. Washington, D.C.: CGAP, July. http://www.cgap.org/sites/default/files/CGAP-Focus- ———. 2013. “Strengthening Oversight and Regulation Note-Nonbank-E-Money-Issuers-Regulatory-Approaches- of Shadow Banking. Policy Framework for Strengthening to-Protecting-Customer-Funds-Jul-2010.pdf Oversight and Regulation of Shadow Banking Entities.” Basel: FSB, August. http://www.financialstabilityboard.org/ wp-content/uploads/r_130829c.pdf 10 See also FSB (2015) mentioning the risks of driving cross-border financial transactions into the unregulated sector due to the decline of correspondent banking services offered by international banks. AUTHORS: Timothy Lyman, Leesa Shrader, and Olga Tomilova