Assessing the Interconnectedness between Cross-Border Shadow Banking Systems

Abstract

This paper investigates the interconnectedness among cross-border shadow banking systems using a broad measure of shadow banking defined by the Financial Stability Board. We find these interconnections are tenuous during tranquil periods, but the systems are significantly linked in times of tightening global liquidity conditions. The interconnectedness can be mostly explained by investors’ search-for-yield behaviour, financial linkages between banks, capital stringency and demand from institutional investors. After controlling for effects of these driving factors, the interconnections are generally insignificant, except the shadow banking system in North America remains influential worldwide. The results reflect that the shadow banking system in North America cannot be explained by conventional risk factors as it is far more complicated than those in other economies. Our finding highlights that the spillover risk of shadow banking is not limited by national boundaries, which requires policymakers and regulators to co-ordinate closely with their foreign counterparts. It also draws a possible policy implication for introducing necessary macro-prudential policies, such as monitoring banks’ exposures to shadow banking risk and ensuring adequate supply of alternative safe assets, to mitigate the risk of shadow banking being materialised.