Taking a functional approach to understanding shadow banking: a critical look at regulatory policy

Abstract

The interpretation of ‘shadow banking’ and the mapping of the shadow banking universe is the subject of much academic commentary and policy discussions. This is because ‘shadow banking’ is often used as a catch-all term to refer to financial activities and transactions that may not be subject to traditional realms of regulation, but the amorphous nature of the term is unsatisfactory for informing debates on regulatory perimeter and policy. Often, a ‘functional’ approach is suggested in order to understand the nature of financial activities and transactions that are lumped into the shadow banking category. The functional approach focuses on the economic function of the financial activity in question, regardless of the type of institution carrying it out. By looking at the economic function performed by the financial activity in question, one may better be able to ascertain the underlying demand and supply for such function and the risks that such functions give rise to, particularly whether systemic risk is implicated. The approach may also highlight the functional similarities and differences with already-regulated financial activity in order to form views as to the regulatory perimeter for shadow banking activities. The functional approach to shadow banking is therefore a prima facie useful approach to surveying the universe of shadow banking and informing the policy-making process in relation to shadow banking activities and transactions at national and international levels. This chapter however raises queries as to the limitations of the functional approach, and whether such limitations would ultimately hamper the development of regulatory policy. In particular, we question whether the functional approach is too embedded in market-liberal assumptions, and stymies imagination in regulatory design by converging upon ‘like-for-like’ analyses and applications. Further, we query whether the functional approach, though conceptually promising, is subject to the legal arbitrage that it seeks to overcome. Nevertheless, this chapter does not deny the achievements made by adopting the functional approach and suggests how it should be put to optimal use.