I’m a Banking Expert: What Is ‘Shadow Banking’ and How Can It Affect Investing?
Written by
Marc Guberti
Edited by
Rebekah Evans
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Most financial institutions are regulated. They offer transparency and there are restrictions that prevent them from implementing high-risk investment strategies with your money.
However, there are also shadow banks that don’t abide by traditional rules. These banks are riskier to work with. Some of them can tank your fortune, but others end up crushing the stock market. If you want to jump into the world of shadow banking, there are a few things you should know before getting started.
Also here are the pros and cons of traditional versus online banking.
What Is Shadow Banking?
Shadow banking is unregulated banking. There aren’t as many rules or restrictions that govern them. These banks can offer a greater range of financial products and services for their customers.
Jim Pendergast, General Manager of altLINE by The Southern Bank, explained which institutions count as shadow banks.
“Shadow banking doesn’t include traditional banks. Instead, financial institutions such as hedge funds, private equity funds and non-bank mortgage lenders are examples of shadow banks,” he said.
These banks give consumers and businesses a place to go for riskier financial products without compromising traditional banks. However, some shadow banks, especially hedge funds, require you to lock up your capital for an extended period of time. That’s part of the reason shadow banks are more risky than traditional banks.
How Do Shadow Banks Affect Stock Portfolios?
Shadow banks can grow your portfolio under the right conditions, but they aren’t for everyday investors. You need a high risk tolerance to get involved in this industry and the results vary greatly.
“Since shadow banking involves working with unregulated lenders and institutions — it’s risky, especially if you don’t do your due diligence on who you’re partnering with. However, if you choose the right partner to work with, shadow banks can help grow a portfolio,” Pendergast said.
Shadow banks have more flexibility with leverage, shorting stocks and accessing derivatives. These institutions can also give out loans with more generous requirements and serve consumers who would be rejected by traditional banks.
Some shadow banks primarily serve investors, while others offer loans to consumers. There’s a lot of variability and that leads to plenty of different outcomes.
“Ultimately, the results of shadow banking have to be determined on a case-by-case basis. Working with a shady institution or one that doesn’t know what they’re doing can tank a portfolio, so doing a full-scale background check of a shadow bank before signing the dotted line is absolutely pivotal for anyone choosing to use them to make money,” he added.
Should You Put Your Money in a Shadow Bank?
Shadow banks aren’t for everyone. They don’t have the same assurances as traditional banks and can lose your investment. Some shadow banks are sketchy or filled with inexperienced workers and you don’t have much recourse if things go wrong.
While you may not want to turn down shadow banking completely, Pendergast explained the amount of effort you should put in before committing to a shadow bank.
“Do a ton of research before working with a shadow bank. And before doing so, determine your risk tolerance. You must set standards, particularly a certain level of required transparency and risk aversion from any potential institution you decide to move forward with,” he said. “Investigating shadow banks can be challenging because there’s usually far less transparency than regulated banks. One thing you can do is look up reporting requirements for your lender, so you know when and how often you’ll receive updates.”
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Sources
- Jim Pendergast, altLINE by The Southern Bank
