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Embedded Finance and the Shadow Banking System

Embedded Finance and the Shadow Banking System





The shadow banking system plays a critical role in the traditional ecosystem of banking and financial institutions, reflecting an interconnectedness between these conventional institutions and financial markets. The interrelationships between shadow banking systems and traditional banking and financing reveal the emerging complex linkages throughout the financial marketplace.

Today, the shadow banking system is emerging from one of embedded finance’s most innovative incarnations. It is an essential detail because at the core of embedded finance is its integration of banking and financial services into non-banking and non-financial products and services. It is within this virtual space, a shadow per se,  that shadow banking’s intermediary positioning is, in itself, integral to the innovations of embedded finance.

Defining the shadow banking system.

In the main, shadow banking is considered a credit intermediation outside the conventional banking and financial system. However, shadow banking is more complex and convoluted than simply being a credit intermediary. Instead, shadow banking is a sophisticated amalgam of many activities contributing to the perceived vulnerability of the banking and financial systems.

The variety of financial activities, institutions, and instruments involved in shadow banking do not lend themselves to a classic definition per genus et differentiam (by race and meaning). Attempting to simplify the explanation of shadow banking is a moot attempt because of the complexity and convolution of the [shadow banking] system.

Put simply, the shadow banking system is known as the “parallel banking system,” a system that has generated many unconventional idioms that reference it, including “securitized finance,” “market-based credit system,” ‘non-bank credit intermediaries,” and “network finance.” These many definitions and designations of shadow banking only add to any misinterpretation already lost to its indefinable pretence.

However, in [academic] literature, the definition of shadow banking has been more definitive, with the innovation defined in two main threads.

One thread defines this intermediation by the nature of the market entity that carries it out. The non-bank financial institutions behave similarly to banks. They are less regulated, especially when conducting maturity, credit, and liquidity transformation, including brokers/ dealers, finance companies, hedge funds, investment companies, money market mutual funds (MMMFs), peer-to-peer lenders, private equity funds, and other non-bank financial institutions. These [entities] are geared towards performing credit intermediaries – namely, taking savings from lenders and channeling them toward borrowers.

Furthermore, they can be identified by the tools that they use, for example, a repurchase agreement (repo), a function where a contract can borrow financial collateral. Depending on the ‘quality’ of the collateral, the credit enhancement and repo terms and conditions (T&Cs) can generate money-like liabilities; however, these characterizations are static because they rely on the list of activities and/ or entities.

The other strand defines shadow banking by the nature of the market activity. This strain considers shadow banking as a chain of activities between banking and financial institutions and different institutional sectors using a variety of financial instruments such as banks, collateral services, deposit-taking and lending,  securitization, and wholesale funding arrangements by non-bank institutions. These activity-based definitions may or may not exclude credit intermediaries performed by banks.

Activity-based definitions of shadow banking are “all financial activities, except traditional banking, which require a private or public backstop to operate,” a last-resort risk-adsorption commitment operating when all other insurance aspects have failed.

Many definitions of shadow banking are complex and convoluted. The shadow banking system operates parallel to the traditional banking and financial institution systems, providing credit and other financial services to borrowers who may not have access to conventional [bank and financial institutional] loans.

The Benefits of the Shadow Banking System.

The shadow banking system offers several benefits, including increased credit availability and reduced transaction costs. The shadow banking system provides credit and financial services to borrowers who may not have access to conventional,  traditional bank loans, such as small and medium-sized enterprises (SMEs). Moreover, the shadow banking system operates with lower transaction costs than traditional banks and financial institutions, making it an attractive alternative for borrowers, SMEs, and the unbanked and underbanked.

Another benefit of the shadow banking system is its ability to offer more customized and flexible financial products. They can provide borrowers with these more customized financial products and services based on their specific needs, such as personalized loans or investment products.

The Challenges of the Shadow Banking System.

Despite the numerical benefits of the shadow banking system, there are also challenges. One of the most significant challenges is the potential for systemic risk. Because the shadow banking system operates outside of the traditional banking and finance industries ecosystem, they are less regulated, meaning there is less oversight, protection, and accountability. This lack of regulation increases the potential for systemic risk and threatens financial stability.

Another challenge of the shadow banking system is the potential for moral hazard, for corruption. Because shadow banking intermediaries are not subject to the same regulations as traditional banks and finance companies, they can engage in and conduct riskier behavior to achieve higher returns and more significant dividends for their shareholders. This risk-taking behavior can lead to more ‘hazard’ and more corruption, where intermediaries take on excessive risk, knowing they will not bear the cost of any losses.

The Role of Embedded Finance in the Shadow Banking System.

Embedded finance is essential in developing and regulating shadow banking and integrating financial services into non-banking and non-financial products and services. Embedded finance proffers greater oversight and regulation of the shadow banking system.

For example, embedding embedded finance services into supply chain finance or factoring in any concerns or issues in the situation can provide greater oversight and transparency, reducing the potential for corruption, fraud, and other illicit activities. Furthermore, embedded finance enables greater access to banking, credit, and financial institutions for the unbanked and underbanked. By integrating banking and financial services into non-financial products or services, embedded finance can provide greater access to credit for SMEs and the unbanked, underbanked, and underserved borrowers.

Conclusion … with Youtap.

In conclusion, in this 4th Industrial Age, financial intermediation has become increasingly integrated with capital markets. Financial intermediation is an adaptive and adoptive response to the advancements, developments, and innovations of the FinTech, banking, and finance industries. In this emerging and fluid framework, traditional banking represents a fraction of the financial institutions. Banks have expanded their shadow banking activities, while the shadow banking system has emerged as an innovative and increasingly important part of the banking and financial industries.

Shadow banking differs from relationship banking because debt relationships are typically organized via marketable securities and repo liabilities supported by tradable collateral. The presence of collateral characterizing such private promises to pay confers shadow banking its distinctive characteristics. Moreover, this presence of collateral represents the personal promises to grant shadow banking its unique character.

In modern banking and finance infrastructures, the marketplace has developed an intricate intermediary exchange of money proper, with shadow banking as a mechanism that relies upon the liquidity of the underlying collateral. The only [real] difference with [independent] shadow banking is the direct access to government guarantees, such as the liquidity put by central banks and the credit guarantees of the public sector.

The shadow banking system provides credit and other financial services to borrowers who may not have access to traditional bank loans. It subsequently offers an increased opportunity to obtain credit and reduce transactional costs.

The 4th Industrial Age has become increasingly integrative. Financial intermediation is an emerging narrative throughout the FinTech ecosystem that supports shadow banking. As a FinTech, Youtap continues to generate and develop innovative software that helps open banking and the underbanked, embedded finance and the unbanked, and by proxy, the emerging replication that shadow banking is managing to address with conventional banking systems. As embedded finance and shadow banking continue to provide more cost-effective and efficient functions, Youtap will continue to produce software that streamlines the FinTech process and the digitalization of the modern world.

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