[SINGAPORE] One of the things that keeps Citigroup chief executive Vikram Pandit awake at night is the vast amount of capital flowing into the unregulated financial system, or what is often known as shadow banking.

The size of the non-bank financial sector in the United States - where Mr Pandit is based - has grown from half the size of the total financial system in 1990 to two-thirds today.

"Identifying and properly regulating non-bank financial institutions are vitally important tasks," said the India-born American in a speech in Singapore yesterday. "Every piece of regulation we are talking about has but one goal - to enhance the safety and soundness of the financial system."

But this goal, he explained, was unlikely to be achieved if more rules were imposed on the formal banking sector while leaving the non-bank financial sector relatively untouched.

Shadow banking is a system under which non-banking financial firms lend money via a wide range of channels, avoiding the stringent scrutiny that is usually applied to banks.

Speaking at the Citi Bicentennial Lecture event hosted by the Lee Kuan Yew School of Public Policy, Mr Pandit said that costs and restrictions imposed on activities conducted by regulated bank entities would push those activities into unregulated or less regulated financial entities.

"As a result, not only is risk not reduced in the system, it may actually rise as the non-bank financial system expands, and the incentive to embrace risk there increases," said the 55-year-old, adding that investors recognised such opportunities afforded by light regulation on the shadow banking system.

This, he said, was one key reason why stocks in these companies have soared 23 per cent this year alone.

"A level playing field is essential for systemic safety but there are too few voices recognising its importance. Making the same or similar rules apply to the whole system should be at the top of the agenda," said Mr Pandit. "Otherwise, all our great work could be for naught."

But with thousands of such shadow banking entities out there, the sheer size and complexity of the system meant that direct supervision alone was not a practical solution.

"It's impossible for even the most effective regulatory body to see every transaction, trade, asset, or loan. Stronger product regulation could help address many issues that supervision cannot adequately oversee," said Mr Pandit.

He gave the example of how a consumer might assume that a credit card with the lowest annual percentage rate is best, but this was not always true.

Similarly, when buying a car, a person would be more likely to pick the financing plan with the lowest up-front cost. But once other costs and fees are included, this car was often more costly than another with a higher monthly payment.

"As we learned from the credit crisis and housing bubble, bad individual consumer decisions are not necessarily isolated events that hurt only the decision makers," said Mr Pandit. "In the aggregate, they can threaten the prosperity of the entire global economy."

Safety and soundness could not be accomplished through regulation alone, he argued. Banks, too, have core responsibilities that they had to shoulder, with the most important being establishing and maintaining the right culture.

"Systemic safety relies on the culture of each individual bank. If that culture is sound, the bank will be sound. The more banks that have a strong culture, the safer the system will be. It's as simple as that."