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Banking's Dark Matter

Statistical physics sheds light on shadow banking activity

05/12/2013 - Trieste

Conventional wisdom holds that a firm's growth is proportional to its size. So when a research team of economists and physicists noticed an anomaly related to the growth rates of the world's largest global firms--which are dominated by financial firms--their curiosity was piqued. Why were the asset sizes of these firms not as high as the theoretical projections would make them?

The answer could be due to shadow banking activities, according to recent research by ICTP physicist Matteo Marsili. In a paper titled "The Interrupted Power Law and the Size of Shadow Banking", Marsili, of ICTP's Condensed Matter and Statistical Physics section, and co-authors not only attribute this deviation to shadow banking, but also say that the anomaly provides a basis to estimate the size of the shadow banking system. Their research shows that shadow banking activities have increased sharply since 2010.

Shadow banking was a major factor in the 2007-2008 financial crisis. It refers to credit intermediation activity that occurs outside the regulated financial system. This includes the securitization of loans (e.g. mortgages) into Asset Backed Securities (ABS) and unsecured short term lending activity in the financial industry. Because of their complexity and degree of intertwinement, shadow banking activities could contribute to lack of transparency, mispricing and to the instability of the global financial system. Having a way to measure shadow banking's hidden impact could help improve oversight of an industry that is increasingly complex.

Marsili and his co-authors--Davide Fiaschi of the University of Pisa and Imre Kondor of the Parmenides Foundation--have devised a simple and robust formula to estimate the size of the shadow banking system using publicly available data from the Forbes Global 2000 list. Using the formula, they have been able to propose a more accurate estimation of shadow banking activities that could account for the drop off in assets by the top finance firms that deviate from power laws governing the growth of firms.

A updated size estimate of shadow banking by the Financial Stability Board for 2012 shows that the activities now constitute a US$71 trillion industry (up $5 trillion from the year before). "This shows that the sector is growing--as predicted by us--contrary to previous estimates that suggested a saturation," says Marsili. To put the size of shadow banking into perspective, he adds that the total money circulating in the whole world is much less than the size of shadow banking.

The article was published by (arXiv:1309.2130) and is available here. (