Final answer:
Shadow banking refers to financial intermediaries like hedge funds and money market funds providing banking services without regulation. They engage in maturity and liquidity transformation, funding long-term loans with short-term borrowings, which increases risk. Their funding profile consists largely of short-term debt, making them vulnerable to market conditions.
Step-by-step explanation:
The shadow banking system refers to the collection of financial intermediaries that operate outside traditional regulated banking systems. These institutions provide similar functions to banks but do so through different mechanisms and without the same regulatory oversight. Institutions that comprise this industry include hedge funds, money market funds, structured investment vehicles (SIVs), and other non-bank financial entities.
Maturity and liquidity transformation is a process where shadow banking institutions fund long-term loans with short-term borrowings, creating a mismatch in the maturity and liquidity of their assets and liabilities. This can increase the risk of defaults or runs on these institutions during periods of financial stress.
The funding profile of these institutions typically includes short-term debt instruments such as commercial paper, and they often rely on the repo market for secured short-term borrowing. Due to their reliance on short-term funding, shadow banks are susceptible to market fluctuations and investor confidence, which can make their operation riskier than traditional banks.