DAVOS, Switzerland (Reuters) - Unconventional lenders that have enjoyed a cosy spot while central bankers were busy trying to make banks stronger should watch out as shadow banking is coming back on to regulators' agenda.
Shadow banking, broadly described as intermediation by non-banks such as hedge funds, private capital and venture funds, has so far escaped traditional banking regulation even though some regulators say it worsened the global financial crisis.
Rebuilding bank capital and the fight to save the euro have taken absolute priority over the past five years.
But Financial Stability Board head Mark Carney told the World Economic Forum in Davos that central bankers will finally be addressing this "forgotten bit of reform" as they try to complete a overhaul of financial regulation over the next two years.
"Shadow banking, over-the-counter derivatives, these are the areas that absolutely amplified the last crisis and will do so again unless we complete our agenda," said Carney, who will leave his current job of Bank of Canada governor to head the Bank of England in July.
The shadow banking sector has been booming since the onset of the global financial crisis in 2007 and stood at $67 trillion worldwide last year according to data from the FSB.
The fact that banks had been forced to hoard capital to build larger buffers against risks has opened up room for new, non-bank players to come into these segment, especially to provide credit to smaller firms.
"Shadow banking is a reality. Investors that had been traditionally providing equity are now providing debt," said Stefano Aversa, co-president of AlixPartners.
"This is not just the traditional loan-to-own space but we also see much loan-to-loan to fill up the gap created by the credit crunch."
The FSB is expected to make proposals on how to regulate this dark area of the financial sector before the G20 autumn summit in Russia, where the issue will be debated, regulatory sources told Reuters.
The issue has become controversial also in China, where the $2 trillion sector has come under more closer scrutiny after the default of an unregulated short-term fund distributed through a Shanghai branch of Hua Xia Bank Ltd (600015.SS).
Such high-yield products are known locally as 'wealth management products'.
"You can't say shadow banking is a bad thing simply because a lot of people don't understand it," argued Hony Capital CEO John Zhao, whose firm has $7 billion in assets under management.
"When a country's economy is growing as fast as China's, it's inevitable that different forms of financing will appear. They serve real needs, and serve to fill little areas that the banking system cannot reach."
JP Morgan Chase (JPM.N) CEO Jamie Dimon also defended the sector at a panel session in Davos, saying they provided necessary services to the economy.
But AlixPartners' Aversa conceded that there was an issue when it came to transparency.
"We've seen a lot of activity move away from the banks, to the capital markets," Zhu Min, deputy managing director of the International Monetary Fund said.
"Both the banks and the shadow banks should have a proper regulatory framework to govern them."
Writing by Lisa Jucca, Additional reporting by Kelvin Soh; editing by Jason Neely