Shadow Banking
Non-bank financial intermediation operating outside traditional banking regulation
Category: Financial Instruments
Difficulty: Advanced
Definition
Financial companies that act like banks but arenāt regulated like banks. They create credit and take risks without the safety nets that protect regular banks.
How It Works
What Shadow Banks Do: - Lend money and create credit - Bundle loans into securities to sell - Use short-term funding for long-term investments - Take on risk without deposit insurance
Main Players: - Investment banks - Money market funds
- Hedge funds - Special purpose companies
Key Activities
Securitization - Take mortgages, car loans, credit card debt - Bundle them together into securities - Sell pieces to investors - Spreads risk but can hide problems
Wholesale Funding - Banks lend to each other overnight - Use repos (repurchase agreements) - Money market funds provide cash - Works until confidence disappears
The 2008 Crisis
What Went Wrong: - Too many bad mortgages bundled into securities - When housing prices fell, securities became worthless - Shadow banks couldnāt get funding - Credit markets froze
Famous Failures: - Lehman Brothers collapsed - Bear Stearns had to be rescued - AIG needed massive bailout - Money market funds nearly broke
Why It Matters
Benefits: - Provides more credit for economy - Creates investment opportunities - Spreads risk around - Can be more efficient than traditional banking
Risks: - No deposit insurance safety net - Can amplify economic cycles - Creates systemic risk - Hard for regulators to monitor
The 2008 Lesson: Shadow banking can grow too big and threaten the entire financial system.
Current Status
After 2008: - More regulation and oversight - Banks hold more capital - Some shadow banking moved to new areas - Still exists but supposedly safer
New Concerns: - Corporate bond ETFs - Cryptocurrency exchanges - Online lending platforms - International coordination challenges
Bottom Line
Shadow banking provides useful financial services but can create dangerous systemic risks. The 2008 crisis showed what happens when it grows too large without proper oversight.
Further Reading
Regulatory Analysis: - Shadow Banking: Strengthening Oversight and Regulation - Financial Stability Board (2011), free PDF - Shadow Banking and the Financial Crisis - Federal Reserve Economic Data
Crisis Analysis: - The Financial Crisis Inquiry Report - Official government report, free PDF - Systemic Risk and the Shadow Banking System - IMF Working Paper, free PDF