Undergraduate Economic Review

Volume 16 Issue 1 Article 17

2019

The Substantial Growth of Shadow Banking, Financial Technology

and Digital Currency and Their Respective Roles in Shaping the
Next Financial Crisis
Vardhan S. Chulani Mr.
Indiana University - Purdue University Indianapolis, [email protected]

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Recommended Citation
Chulani, Vardhan S. Mr. (2019) "The Substantial Growth of Shadow Banking, Financial
Technology and Digital Currency and Their Respective Roles in Shaping the Next Financial
Crisis," Undergraduate Economic Review: Vol. 16 : Iss. 1 , Article 17.
Available at: https://digitalcommons.iwu.edu/uer/vol16/iss1/17

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The Substantial Growth of Shadow Banking, Financial Technology and Digital
Currency and Their Respective Roles in Shaping the Next Financial Crisis

Abstract
Based on Goldman Sachs’ model and the state of current affairs, an underlying possibility of a financial
crisis occurring in the foreseeable future does exist. This could be due to ongoing trade war and
negotiations with different countries, the new policies introduced by political parties and their respective
impacts, high amounts of corporate and student debts along with auto loans in the economy, thus
indicating signs of excessive leverage and resulting in depressing consumer confidence. International
issues such as Brexit, the existing currency and debt crisis with Turkey, and China’s debt bubble could
also contribute to the global growth slowdowns. Experts such as Nouriel Roubini, Brunello Rosa, Diego
Zuluaga, Arthur Guarino, and many more believe that the macroeconomic variables highlighted above are
the probable catalysts of the next crisis. Therefore, this paper discusses two issues, Shadow Banking and
Financial Technology, which could potentially imbalance the financial markets but are not well addressed
to the stakeholders of the macroeconomy, regarding their causes and implications. Moreover, it chats
about how they stemmed from the Global Financial Crisis (GFC) of 2000-2008 and how they pose growing
risks to the current monetary system. This paper does not consider or highlight the influences of the
global pandemic known as the COVID-19 pandemic.

Keywords
Financial Technology, Financial Crisis, Shadow Banking, Regulation, Cryptocurrency

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 Chulani: The Substantial and Threatening Growth of Shadow Banking and Fintech

In order to predict the root causes of the next financial crisis, it is imperative
to learn about factors which were instrumental in the rise and fall of money
markets in the past and map their presence in the strong growth trajectory of the
U.S. economy in recent times. In 2010, Mark Jickling, a Financial Economist at
the Congressional Research Crisis, compiled a report titled as Causes of the
Financial Crisis, which briefly highlighted numerous reasons that contributed to
the intensity of the crisis and instability of various markets. 1 The countless
reasons attributed to recent episodes of various financial crises stem from the
banking system's credit expansion strategies, the unregulated use of financial
instruments, lenient supervision of banking practices, and decline in
underwriting standards, which contributed to the global downturn. This
behaviour created excessive leverage in the economy and promoted financial
liberalization with widespread repercussions leading to propagate the possibility
of financial shocks, bubbles, and asset price busts. These were crucial signs of
economic distress recognized in the case of the Dot-Com bubble and the real-
estate boom, during which the share prices in the tech sector and property rates
rushed to large numbers, thus triggering the monetary crisis.
Additionally, as the equities and securities markets expanded, financial
models became more innovative and complex. It became more difficult to track
the flow of money, evaluate the quality of financial products, and assess the
authenticity of the source when traded between buyers and sellers. The chances
of a systemic risk increased substantially due to the rising opaqueness in the
financial system and the interrelatedness of various agents. Furthermore, the
crucial contribution of financial innovation developed new instruments and
market structures, namely Over-the-Counter Derivative (OTC), with institutions
benefitting from them in an unregulated secondary market along with
transforming the maturity date had a significant impact on the financial markets.
With sensitive and classified information trading in an informal and unorganized
market, this resulted in a lack of transparency and spreading risks, thus reducing
individual accountability.
Over and above that, the proliferation of the shadow banking industry has
contributed to jeopardizing the financial equilibrium in several markets. The
unregulated sector of shadow banking has the edge over other financial
institutions as they act as non-depository financial intermediaries that specialize
and engage in lending practices by facilitating credit from liquid markets.
Considered as one of the significant contributors of the 2008 financial crisis,
shadow banking aims to earn higher returns by providing funds loans in exchange
for collateral from the borrowers, repackaging the loans into long-term
investments such as securities such as CDOs, bonds and mortgages to agents in

1
(Congressional Research Service, 2019)

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 Undergraduate Economic Review, Vol. 16 [2019], Iss. 1, Art. 17

secondary markets to invest in them for a return on its maturity. By engaging in

maturity transformation, borrowing funds to invest, and not accepting deposits,
its operations and activity are not subjected to any regulations like traditional
banks, which leads to having high leverage and performing actions such as
securitization, which can multiply the possibility of systemic risk and financial
crisis as it impacts various components of the financial system.
To date, many regions around the globe, such as the Middle East and the
European countries still have not recovered from the effects of the GFC.
However, over the last decade, the shadow banking system has witnessed
substantial growth, rising to a $52 trillion industry in 2017, as claimed by the
Global Monitoring Report on Non-Bank Financial Intermediation published by
the Financial Stability Board (FSB). 2 According to a report titled as The Credit
Creation Functions of the Shadow Banking System and the Challenge on the
Monetary Policy, published by the Journal of Financial Research, author Li
B writes, "there is more competition in non-interest income market than loan
and deposit market in China. Less competition in the loan market increases
bank profits and shadow banking also improves the profitability of Chinese
banks." 3 With the increased regulation and reduced competition in the retail
banking sector since 2008, along with the reduced bank leverage ratio, a
substantial proportion of the supervised banking activity has shifted to the "Peer-
to-peer (P2P) lending" system.
Posing as a significant source of systemic risk, this network of
unregulated financial intermediaries comprising of sophisticated financial
vehicles & investment and financial holding companies, along with their
interlinked transactions, could have a severe impact on the economy and plague
financial services and monetary system. Since the entire market is developed on
the foundation of the collateralization process, the excessive leverage is created on
multiple underlying assets collateralized and securitized among several lenders.
As liquidity pressure builds up, the sale of significant positions with a lack of
understanding and valuing assets engender a domino effect, thus influencing
various economic agents. Furthermore, as the central bank does not support
shadow banking, the lack of funds to provide will eventually form a shadow
banking crisis.
Several vital indicators and influencing determinants play integral parts in
the formation of the next boom, bust, and recession. After recognizing the
ascending delinquency and unemployment rates during the 2008 GFC, the
Federal Open Market Committee's (FOMC) weapon of choice to deal with the
decline in the economy was the Expansionary Monetary Policy. By effectively
implementing the policy and using financial instruments, particularly the interest
2
(Financial Stability Board, 2019)
3
(B and G, 2011)

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 Chulani: The Substantial and Threatening Growth of Shadow Banking and Fintech

rate and quantitative easing methods, households and firms were inclined to
raise consumption and investments. This was due to the low cost of borrowing
and increased supply and circulation of money, mainly credited to large-scale
asset, mortgage-backed securities, and government bond purchases by the Fed.
However, this optimism was stretched till 2016, when the credit-fuelled
economy displayed signs of rising inflation rates escalating from 1.27 percent
in 2016 to 2.54 percent in 2018, according to economic statistics site Statista. 4 In
order to minimize the possibility of an inflationary spiral and its consequences,
quantitative tightening, also known as the contractionary fiscal policy, was
enforced to lower the price levels. As a result, the interest rate hiked four times
during 2018, thus reducing its attractiveness and slowing down business activity.
Secondly, the emergence of financial technology, cybercrime, and the
monetization of new cryptocurrencies are the new areas of concern which
could potentially hamper the financial stability and spark an economic
downturn. However, as cyberspace and trading platforms grow, the volume,
value, and sensitivity of information collated and organized increases, with
many individuals exposing their data either unintentionally or purposefully
for using certain services. Therefore, there exists a high chance of vital data
being leaked to unethical groups due to internal and external security breaches,
which could be shared without consent among various stakeholders without
informing how will it be utilized. With improved accessibility to utilize
modern financial technology, thanks to digital transformation, and easier
penetration into the payment systems of various sophisticated platforms, cyber
spying corrupts the precious data of various economic parties, thus risking the
Intellectual Property (IP) and generating financial losses with an approximate
range from $ 600 billion to $1 trillion. 5 Although it offers multiple benefits such
as reduced capital costs, avoiding third-party participation, and improved
efficiency, it is of the utmost importance to take measures to develop a secure
network and mitigate cyber risks to prevent cyber espionage, manipulation of
financial information, and sparking adverse technological shocks in markets.
In March 2019, KPMG, an accounting and management consulting firm,
voiced their concern regarding this matter by outlining the implications, risks,
and regulations associated with fintech in a report titled as, "Regulation and
supervision of fintech." 6 KPMG highlights that since fintech is a more efficient
and modern yet sophisticated approach towards high-risk financial operations
and services, many consumers and firms are unaware of its nature and
mechanism, hence are not capable or may not possess the skill-set of
pinpointing the risks attached with fintech along with developing the

4
(Duffin, 2019)
5
(Pham, 2019)
6
(KPMG, 2019)

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 Undergraduate Economic Review, Vol. 16 [2019], Iss. 1, Art. 17

methodology to mitigate them. Additionally, the cross-border transactions which

take place beyond the framework of the regulatory and standard-setting bodies are
receiving increasing attention. Furthermore, in a report published on June 2017,
the Financial Stability Board (FSB) corroborated similar concerns as well as
asserted that the periodic testing and upgrading of various systems is critical
for the systematic and sustained operations of fintech, which protect the data
and network from several security violations. 7 With the increased dependency
and alliance with the services of third-party organizations, the potential risks
intensify as well due to the possibilities of a data breach such as an event of
system failure, inferior quality of service, poor resilience, or issues surrounding
data privacy. Therefore, the FSB has exhibited the dire importance of developing
contingency plans to reduce the impact of systems failure and assist with the
recovery of operations. Another approach to validate, secure, and utilize the
information in the most efficient manner is by conducting Privacy Impact
Assessment (PIA) which mitigates the risks associated with technology by a
high margin. This is a logical proposition to eliminate chances of privacy
invasion on a large scale. Apart from this, the systemic importance of each firm in
markets of distinct characteristics, the creation of new financial products, and
the exposure to new methods of distributions and use could lead to severe
financial misconduct. To quote a working paper released by the IMF, “The
threat landscape for MENAP and the CCA countries shows that cyberattacks
are increasing in volume, diversity, and complexity.” 8 Consequently, many
nations are taking steps in response to alleviate the event and impact of
cyberattacks by investing in more secure technology and framework as well as
developing and offering educational initiatives to individuals and employees to
increase their awareness, understanding, and attends to such threats and
situations.
Additionally, since its discovery, the escalating growth of trading
cryptocurrencies on a global scale could lead to the development of the next
bubble, as its massive availability on numerous portals supports the secure
transfer of payments, which is not regulated by a higher authority. If the
monetary policies are too rigid and severe, excessive demand for the speculative
asset could create an asset bubble, which did burst in 2008 after due to a lack of
knowledge and irrational behaviour where everyone followed the same course
of action. Considered as an alternative currency, the proliferation of this
medium of exchange does have the potential to promote criminal behaviour.
In January 2019, Biditex Exchange’s piece of writing, as cited from the popular
publishing platform known as Medium discusses the risks of investing and

7
(Fsb.org, 2017)
8
(International Monetary Fund (IMF), 2018)

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 Chulani: The Substantial and Threatening Growth of Shadow Banking and Fintech

dealing with digital currency in the future. 9 Firstly, since cryptocurrencies are not
regulated and supervised by the central banks of nations, a sound policy and
framework surrounding various digital and virtual currencies for sectors and
subsectors of different scales, platforms, and participants do not exist. Therefore,
several issues arise due to the lack of legal recognition and the ambiguous nature
of this industry, such as dictating the constitutional principles of transactions, the
code of conduct expectations from market participants, the taxation structure
present for transaction types, amounts, and platforms, etc. The officials of the US
Securities and Exchange Commission (SEC) quoted that many players who
practice cryptocurrency trading and investments, do not follow the state laws
mediated by the financial regulatory authorities.
Also, in a research paper titled, “Issues and Risks Associated with
Cryptocurrencies such as Bitcoin,” authored by Félix Brezo and Pablo G. Bringas,
the issues addressed above could lead to crimes and , namely tax evasion. 10
Moreover, they assert that virtual currency platforms are often used for money-
laundering purposes, were tracking the source, destination, and the amount is
close to impossible, thanks to the use of data anonymization software. In another
article posted by The Risk Management Association (RMA), the not-for-profit
professional organization believes that risks around lack of liquidity and cash
crunch exist due to the high transaction costs, low liquidity generating exchange
platforms, and the constant trading of currencies, where actors liquidate as
quickly as possible. 11 Furthermore, the requirements of leading-edge equipment
essential for cryptocurrency mining, trained individuals, the volatility of
various coins, the accessibility to such technology in LEDCs, and countless
reasons from this emerging market could pose risks to its disruption and
jeopardize a part of the financial system.

9
(Medium, 2019)
10
Félix Brezo and Pablo G. Bringas, “Issues and Risks Associated with Cryptocurrencies Such as
Bitcoin,” in Issues and Risks Associated with Cryptocurrencies Such as Bitcoin (Bisbao, Biscay:
IARIA, 2012), pp. 1-7)
11
(Rmahq.org, n.d.)

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