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Banking in the Shadows

September 09, 2016
The financial markets have morphed and changed since their inception. With these changes, an unregulated industry has emerged “in the shadows.” This industry has aptly been called shadow banking.

By Madeline Dalzell, W’19

First of all, what exactly is shadow banking? The term “shadow bank” was coined by economist Paul McCulley [1]. The shadow banking system refers to any financial activity performed by a bank that is not regulated by the Federal Reserve. There are some financial institutions that look like banks and act like banks – but are shadow banks because they are not regulated by the banking regulators. Some examples of shadow banking include hedge funds, money market funds, credit default swaps, and more. The term shadow banking elicits feelings of mystery and nefariousness, but classifying an entity as a shadow bank does not mean their activities are illegal. Shadow banks are not regulated by the Federal Reserve, but other government authorities could and do regulate them, such as the Securities and Exchange Commissions (SEC) or the Commodities and Futures Trading Commission (CFTC).

The Federal Reserve was created to be the regulator for all monetary policy in the United States. Monetary policy is when the Fed controls the supply of money in the country to ensure price stability and establish a target interest and inflation rate. Monetary policy affects how all banks operate and how much money they loan out. The shadow bank system is believed to make up 25% to 30% of the total banking system [2]. If shadow banks are not under the regulatory power of the Federal Reserve, the Fed loses a significant amount of influence and effectiveness when they are trying to conduct monetary policy. Their policies will only affect 70% of the industry’s behavior.

Shadow banking was first discussed after the 2008 financial crisis. As so many other financial products, analysts soon realized that the collapse of this industry was one of the causes leading to the crisis. The industry had a large role in turning home mortgages into securities [3]. Mortgages were packaged into a security and then sold to investors, a financial product commonly referred to as a mortgage-backed security. In 2008, when homeowners started to default on their loans due to bad loaning practices, those mortgage-backed securities started to fail. After the shadow banking industry’s role in the 2008 financial crisis was realized, the Federal Reserve began to collect and publish data on the shadow banking system [4]. Analysts realized the shadow banking system had grown from $25 trillion to $71 trillion in assets in just a few years [5].

Another downfall of shadow banks not being under regulation by the Fed is that that they cannot borrow money from the Federal Reserve in an emergency. Also, deposits into shadow bank products are not covered by insurance. Here’s an example of a shadow banking product going awry:

The Reserve Primary fund, a well-known money market fund at the time, collapsed suddenly in 2008 because of their lack of access to Federal Reserve borrowing powers. A money market fund is a fixed income mutual fund that invests in high quality fixed income sources, such as U.S. treasury bonds and high-rated corporate paper bonds. Also, for money market funds, investors are guaranteed that they will get $1 back for every $1 invested. For a long time, money market funds were equated with bank accounts. Investors believed (incorrectly) their money market fund was insured and safe like the money in their bank accounts. The Reserve Primary fund had 5% of their assets invested in Lehman Brothers commercial paper (the maximum percentage allowed invested in a single entity). When Lehman went bankrupt in essentially one day, the value of Reserve Fund’s assets plummeted. The Reserve Fund had to “break the buck,” meaning that they could no longer guarantee that investors would get $1 back when they withdrew their money, they would only get about $0.97 for every $1. Lots of investors panicked and started trying to withdraw their money and the Reserve Fund quickly collapsed because they weren’t prepared to deal with a mass liquidation of all their assets in order to satisfy investor’s demand for money [6]. The Fund couldn’t borrow from the Fed to keep up with all the withdrawals. The Reserve Fund episode crushed money market fund’s illusion of safety when investors realized their investments in money market funds were not insured against events like this.

Another problem with the shadow banking system is the lack of transparency in the system as a whole, hence the term “shadow bank.” It is hard to tell who owes what and who owes who. There is a lack of disclosure about the value of assets. Governance structure of banks often makes it hard to regulate them due to their complexity [7]. Even estimating the size of the industry is difficult because shadow banks do not report to one single regulator.

The entire financial system as a whole has grown into a net of tangled string. Banking started out simple, with banks providing ways for investors to deposit money and receive loans. Now, banking has bled into the financial sector, while the financial sector has bled into the banking sector. What is left are tangled strings: you can’t tell which piece of the string is the start, which piece connects to what, and where the piece of string ends. Lack of regulation has caused a machine that, at this moment, seems unstoppable growth-wise. It would take major action by one of the government regulators to establish regulation for all shadow-banking practices that the slow-pace of government can’t compete with. For now, the best we can do is to try and follow the string as long as possible and keep up with the growth of the industry. 

References

  [1] L. Kodres, “What is Shadow Banking,” International Monetary Fund, June 2013. [Online]. Available: http://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm. [Accessed: July 13, 2016].

  [2] “Shadow Banking System,” Investopedia, 2016. [Online]. Available: http://www.investopedia.com/terms/s/shadow-banking-system.asp. [Accessed: July 13, 2016].

  [3] L. Kodres, “What is Shadow Banking,” International Monetary Fund, June 2013. [Online]. Available: http://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm. [Accessed: July 13, 2016].

  [4] L. Kodres, “What is Shadow Banking,” International Monetary Fund, June 2013. [Online]. Available: http://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm. [Accessed: July 13, 2016].

  [5] “Shadow Banking System,” Investopedia, 2016. [Online]. Available: http://www.investopedia.com/terms/s/shadow-banking-system.asp. [Accessed: July 13, 2016].

  [6] D. Henriques, “Lehman Loss Just the Start for Money Fund,” The New York Times, Feb 26, 2009. [Online]. Available: http://www.nytimes.com/2009/02/27/business/27fund.html?rref=collection%2Ftimestopic%2FReserve%20Fund%2C%20The&action=click&contentCollection=business&region=stream&module=stream_unit&version=latest&contentPlacement=54&pgtype=collection. [Accessed: July 13, 2016].

  [7] L. Kodres, “What is Shadow Banking,” International Monetary Fund, June 2013. [Online]. Available: http://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm. [Accessed: July 13, 2016].

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