Shadow banking and the strategy review

Understanding how the economy works

Our job is to keep prices stable. To do that well, we need to understand how the economy works. Our economy is like an engine made up of different parts. One key part is the financial system. This includes banks, insurance companies and financial markets, among others. The financial system helps money flow through the economy when and to where it is needed.

A changing economy, a changing financial system

The economy has changed a lot since we last carried out a strategy review, in 2003. One of those changes is how companies fund themselves. In the past, they often simply borrowed from banks. While bank lending is still a very important source of funding in the euro area, other ways are now becoming more common. For example, larger companies increasingly finance themselves by issuing corporate bonds. And these corporate bonds in turn are often snapped up by financial institutions that can act like normal banks but are not subject to as many rules. That is why they have been called “shadow banks”.

Our monetary policy works through the financial system

It is important to keep on top of developments like these because our monetary policy reaches people, businesses and governments through the financial system. That is why the Governing Council discussed shadow banking as part of our strategy review.

It is no longer just about interest rates, but other monetary policy tools too

How we use our monetary policy tools depends in part on the way in which the financial system functions to channel funds throughout the economy. Take our interest rates. By adjusting our interest rates, we influence how expensive it is for people and companies to borrow money from banks. That in turn affects their spending and investment, and in turn how prices develop.

But if lending by banks becomes less important for those who need credit, this also affects how changes to our interest rates affect wider economic activity. This is one of the reasons why we use other monetary policy tools to help keep prices steady. Look at our asset purchases, for example. By buying assets – like corporate bonds – we can make it cheaper for companies to fund themselves in this manner. That can help the economy and support price stability.

Shadow banking can be risky for the economy

It can be good news that companies are no longer as reliant as they once were on loans from banks. If banks are not doing well, they may reduce how much they lend. That may in turn hurt those companies that need access to funding. Having other sources of financing can be really useful for companies in moments like these.

But there are risks too. For example, shadow banks are not as regulated as normal banks. That means they may take riskier decisions because the rules for them are not as strict. If those decisions backfire, these institutions can be hit by heavy losses. If shadow banks are big enough, this fallout may even make the entire financial system unstable. That can hurt the economy. And because we make decisions with the economy in mind, that affects our monetary policy.

The Governing Council discussed shadow banking as part of its strategy review because it is important to keep these changes in the financial system on our radar. By continuing to understand how the economy works, we can ensure that we make the right decisions to keep prices stable.