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The dangers of 'shadow banks'

Shadow banks control 71 trillion dollars in assets - more than 70 percent of world economic output. Politicians are beginning to voice concern about the implications.

"Shadow banks" have German Chancellor Angela Merkel worried. "When we get together this fall in Australia at the G20 summit, the regulation of shadow banking is the central issue," she told the annual conference of the German Council for Sustainable Development in Berlin Monday (02.06.2014).

The shadow banking sector is an extremely diverse group of markets and institutions. They can be involved in money market and hedge funds, or private equity and special purpose entities. Insurance companies are among the most prominent of these financial intermediaries. They lend to individuals or companies, undertaking bank-like business, but without a banking license.

Snapped up

At the moment the shadow banking system plays a helpful role because it buys bad loans from commercial banks. No matter how many junk bonds come to market, shadow banks absorb them immediately. The result is that regular banks can meet the stricter capital rules and be fit for all kinds of stress tests - much to the delight of politicians and financial overseers. But the downside is that the shadow banks themselves are growing rapidly and are now juggling $71 trillion, according to an estimate by the Financial Stability Board. That's around half the business volume of regular banks.

In other words, the risk posed by toxic assets has not gone away; only the institutions taking that risk have changed. "It's like a hot potato that you pass on," Markus Henn, financial market analyst at anti-globalization activist group Attac, told Deutsche Welle.

Why do shadow banks do this favor for the regular banks? The main reason is the growing pressure on yields. As

central banks flood the markets with liquidity

, while simultaneously holding interest rates near zero, investors are looking for new opportunities. And the shadow banks hope that they can keep passing on these "hot potatoes."

An important role?

Everything is fine as long as interest is paid on the papers. But if investors suddenly want their money back, this could snowball into a big problem - as the 2008 financial crisis showed.

Because some US money market funds invested in Lehman Brothers securities, investors distrusted all such funds and pulled out their money. Spooked investors also caused insurance giant AIG to falter.

Since the shadow banking system is unable to borrow money from the central banks, the picture becomes even bleaker. The shadow banks are closely intertwined with the regular banks through loans and could drag them down in the event of a crisis. That's one reason why shadow banks may prove to be a critical part of the financial system - one that may have to be rescued by the state.

Lack of transparency is the biggest problem

Politicians and financial regulators agree that shadow banks need regulating. The only question is how. "The biggest problem is that we have a great lack of transparency, which the authorities openly admit," Henn said. He called for shadow banks to make mandatory collateral deposits for credit transactions, just as regular banks are required to do.

Analysts say because the shadow sector knows no borders, action on a worldwide scale is required. "We need a global set of rules for shadow banks," Elke Koenig, President of Germany's Federal Financial Supervisory Authority, said in an interview with German business daily Handelsblatt.

By turning to the G20, Merkel has thus chosen the right forum. But her timing is not the best, something the chancellor herself admitted in Berlin: "The worldwide concern is unfortunately waning as the international financial crisis recedes."