FSB definition of shadow banking paints 'incomplete picture', warns IMF paper

The eurozone's shadow banking sector is only marginally smaller than its US counterpart, according to an International Monetary Fund (IMF) working paper that offers a new measure aimed at capturing more "non-traditional activity" in the financial system.

The FSB is widely considered a leading authority on shadow banking. It has published the flagship global shadow banking monitoring report (GSMR), a yearly analysis of trends and risks within the sector, since 2010.

It defines shadow banks, broadly, as entities that provide credit intermediation but operate outside the regulated banking system.

That definition is challenged in an IMF working paper published yesterday, which warns that other measures of the sector – including the FSB's – fail to account for "non-traditional banking activities carried out by the banks themselves".

The result, they add, is an "incomplete picture" of the shadow banking sector and the "potential vulnerabilities" associated with it. 

Include the banks

According to Shedding Light on Shadow Banking by Artak Harutyunyan, Alexander Massara, Giovanni Ugazio, Goran Amidzic and Richard Walton, shadow banking should encompass all credit intermediation that is "non-traditional from the point of view of the funding source".

This includes all liabilities except "traditional" bank deposits, typically from non-financial corporations and households, including the market funding regular banks use to finance their activities.

According to the paper, "banks' involvement in shadow banking activities can be significant". It finds that non-traditional liabilities are procyclical and display more volatility than traditional liabilities in the US, eurozone and Japan.

Moreover, under this definition of shadow banking, the sector in the eurozone, which relies more on bank lending than capital markets, grows significantly.

"Compared with the US, the share of non-core liabilities issued by [eurozone] banks is much larger, standing at about 70% in the fourth quarter of 2013," the paper notes. The US share is about 10%.

Under the definition, the shadow banking sectors in the US and the eurozone are both estimated at around 100% of GDP.

Previous criticism

The FSB has previously come under criticism for measuring shadow banking activities too narrowly and, therefore, failing to account for potential risks.

In a blogpost published on the IMF's website in September, two Fund officials argued the FSB was severely underestimating the size of China's shadow banking sector by leaving out entities with a "less clearly defined legal status".

"The [FSB] filters out of its estimates those parts of the non-bank financial system that are not formally involved in ‘credit intermediation'," Steven Barnett, division chief in the Fund's Asia and Pacific department, and Shaun Roache, a resident representative in Hong Kong, wrote at the time.

As a result, they argued, the FSB had underestimated the size of China's rapidly growing sector by roughly half, putting it at 25.8% of GDP in its 2013 GSMR, instead of 55%.

Others have also raised the definition issue. Following the release of the FSB's 2014 GSMR in November, JP Morgan warned ostensibly trivial changes to the activities included in the definition of shadow banking could create big differences when interpreting the data.

"After adjusting for entities not truly involved in credit intermediation, the shadow banking system becomes much smaller, almost halved, and is growing at a slower pace," JP Morgan said in a comment.