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The shadow banking system is a term for the collection of non-bank financial intermediaries (NBFIs) that provide services similar to traditional commercial banks but outside normal
banking regulation Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom t ...
s. Examples of NBFIs include
hedge funds A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as ...
, insurance firms,
pawn shops A pawnbroker is an individual or business (pawnshop or pawn shop) that offers secured loans to people, with items of personal property used as collateral. The items having been ''pawned'' to the broker are themselves called ''pledges'' or ...
,
cashier's check A cashier's check (or cashier's cheque, cashier's order) is a check guaranteed by a bank, drawn on the bank's own funds and signed by a cashier. Cashier's checks are treated as guaranteed funds because the bank, rather than the purchaser, is respo ...
issuers, check cashing locations,
payday lending A payday loan (also called a payday advance, salary loan, payroll loan, small dollar loan, short term, or cash advance loan) is a short-term unsecured loan, often characterized by high interest rates. The term "payday" in payday loan refers to ...
,
currency exchanges In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
, and microloan organizations. The phrase "shadow banking" is regarded by some as pejorative, and the term "market-based finance" has been proposed as an alternative. Former
US Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after ...
Chair
Ben Bernanke Ben Shalom Bernanke ( ; born December 13, 1953) is an American economist who served as the 14th chairman of the Federal Reserve from 2006 to 2014. After leaving the Fed, he was appointed a distinguished fellow at the Brookings Institution. Duri ...
provided the following definition in November 2013: Shadow banking has grown in importance to rival traditional depository banking, and was a factor in the subprime mortgage crisis of 2007–2008 and the global recession that followed.


Overview

Paul McCulley Paul Allen McCulley (born March 13, 1957) is an American economist and former managing director at PIMCO. He coined the terms "Minsky moment" and "shadow banking system", which became famous during the Financial crisis of 2007–2009. He is curre ...
of investment management firm PIMCO coined the term "shadow banking". Shadow banking is sometimes said to include entities such as hedge funds,
money market fund A money market fund (also called a money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a hi ...
s,
structured investment vehicle A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, ...
s (SIV), "credit investment funds,
exchange-traded fund An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. they are traded on stock exchanges. ETFs are similar in many ways to mutual funds, except that ETFs are bought and sold from other owners throughout the ...
s, credit hedge funds, private equity funds, securities broker-dealers, credit insurance providers, securitization and finance companies." Still, the meaning and scope of shadow banking are disputed in academic literature. According to Hervé Hannoun, deputy general manager of the
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work thr ...
(BIS), investment banks and commercial banks may conduct much of their business in the shadow banking system (SBS) although most are not classified as SBS institutions themselves. At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks. The core activities of investment banks are subject to regulation and monitoring by
central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
s and other government institutions – but it has been common practice for investment banks to conduct many of their transactions in ways that do not show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors. For example, before the 2007–2012
financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...
, investment banks financed mortgages through
off-balance sheet Off balance sheet (OBS), or incognito leverage, usually means an asset or debt or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance-sheet item. Some companies may have significant amounts o ...
(OBS) securitizations (e.g.,
asset-backed commercial paper Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. Institutional investors usually purchase such instruments in order to diversify their assets and generate short-term gains. Str ...
programs) and hedged risk through off-balance sheet
credit default swap A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
s. Before the 2008 financial crisis, major investment banks were subject to considerably less stringent regulation than depository banks. In 2008, investment banks Morgan Stanley and Goldman Sachs became
bank holding companies A bank holding company is a company that controls one or more banks, but does not necessarily engage in banking itself. The compound bancorp (''banc''/''bank'' + '' corp ration') is often used to refer to these companies as well. United States ...
, Merrill Lynch and
Bear Stearns The Bear Stearns Companies, Inc. was a New York-based global investment bank, securities trading and brokerage firm that failed in 2008 as part of the global financial crisis and recession, and was subsequently sold to JPMorgan Chase. The com ...
were acquired by bank holding companies, and Lehman Brothers declared bankruptcy, essentially bringing the largest investment banks into the regulated depository sphere. The volume of transactions in the shadow banking system grew dramatically after the year 2000. Its growth was checked by the 2008 crisis and for a short while it declined in size, both in the US and in the rest of the world. In 2007 the Financial Stability Board estimated the size of the SBS in the U.S. to be around $25
trillion ''Trillion'' is a number with two distinct definitions: *1,000,000,000,000, i.e. one million million, or (ten to the twelfth power), as defined on the short scale. This is now the meaning in both American and British English. * 1,000,000,000,00 ...
, but by 2011 estimates indicated a decrease to $24 trillion. Globally, a study of the 11 largest national shadow banking systems found that they totaled $50 trillion in 2007, fell to $47 trillion in 2008, but by late 2011 had climbed to $51 trillion, just over their estimated size before the crisis. Overall, the worldwide SBS totaled about $60 trillion as of late 2011.Masters, Brook
Shadow banking surpasses pre-crisis level
, ''
The Financial Times The ''Financial Times'' (''FT'') is a British daily newspaper printed in broadsheet and published digitally that focuses on business and economic current affairs. Based in London, England, the paper is owned by a Japanese holding company, Nikk ...
'', ft.com, 2011-10-27. Accessed 2012-01-16.
In November 2012
Bloomberg Bloomberg may refer to: People * Daniel J. Bloomberg (1905–1984), audio engineer * Georgina Bloomberg (born 1983), professional equestrian * Michael Bloomberg (born 1942), American businessman and founder of Bloomberg L.P.; politician and ...
reported in a Financial Stability Board report an increase of the SBS to about $67 trillion. It is unclear to what extent various measures of the shadow banking system include activities of regulated banks, such as bank borrowing in the repo market and the issuance of bank-sponsored asset-backed commercial paper. Banks by far are the largest issuers of
commercial paper Commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity of rarely more than 270 days. In layperson terms, it is like an "IOU" but can be bought and sold because its buyers and sellers have some ...
in the United States, for example. , academic research has suggested that the true size of the shadow banking system may have been over $100 trillion in 2012. According to the Financial Stability Board the sectors size grew to 100 trillion in 2016.


Entities that make up the system

Shadow institutions typically do not have
banking license A banking licence is a legal prerequisite for a financial institution that wants to carry on a banking business. Under the laws of most jurisdictions, a business is not permitted to carry words like a ''bank'', ''insurance'', ''national'' in th ...
s; they do not take deposits as a depository bank would and therefore are not subject to the same regulations. Complex legal entities comprising the system include hedge funds,
structured investment vehicle A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, ...
s (SIV), special purpose entity conduits (SPE),
money market fund A money market fund (also called a money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a hi ...
s, repurchase agreement (repo) markets and other non-bank financial institutions. Many shadow banking entities are sponsored by banks or are affiliated with banks through their subsidiaries or parent bank holding companies. The inclusion of
money market fund A money market fund (also called a money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a hi ...
s in the definition of shadow banking has been questioned in view of their relatively simple structure and the highly regulated and unleveraged nature of these entities, which are considered safer, more liquid, and more transparent than banks. Shadow banking institutions are typically intermediaries between investors and borrowers. For example, an institutional investor like a pension fund may be willing to lend money, while a corporation may be searching for funds to borrow. The shadow banking institution will channel funds from the investor(s) to the corporation, profiting either from fees or from the difference in interest rates between what it pays the investor(s) and what it receives from the borrower. Hervé Hannoun, Deputy General Manager of the
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work thr ...
described the structure of this shadow banking system at the annual South East Asian Central Banks (SEACEN) conference. This sector was worth an estimated $60 trillion in 2010, compared to prior FSB estimates of $27 trillion in 2002. While the sector's assets declined during the global financial crisis, they have since returned to their pre-crisis peak except in the United States where they have declined substantially. A 2013 paper by Fiaschi ''et al.'' used a statistical analysis based on the deviation from the Zipf distribution of the sizes of the world's largest financial entities to infer that the size of the shadow banking system may have been over $100 trillion in 2012. There are concerns that more business may move into the shadow banking system as regulators seek to bolster the financial system by making bank rules stricter.


Role in the financial system and ''modus operandi''

Like regular banks, shadow banks provide credit and generally increase the liquidity of the financial sector. Yet unlike their more regulated competitors, they lack access to
central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
funding or safety nets such as deposit insurance and debt guarantees. In contrast to traditional banks, shadow banks do not take deposits. Instead, they rely on short-term funding provided either by
asset-backed commercial paper Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. Institutional investors usually purchase such instruments in order to diversify their assets and generate short-term gains. Str ...
or by the repo market, in which borrowers in substance offer collateral as security against a cash loan, through the mechanism of selling the security to a lender and agreeing to repurchase it at an agreed time in the future for an agreed price. Money market funds do not rely on short-term funding; rather, they are investment pools that provide short-term funding by investing in short-term debt instruments issued by banks, corporations, state and local governments, and other borrowers. The shadow banking sector operates across the American, European, and Chinese financial sectors, and in perceived
tax haven A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or ...
s worldwide. Shadow banks can be involved in the provision of long-term loans like mortgages, facilitating credit across the financial system by matching investors and borrowers individually or by becoming part of a chain involving numerous entities, some of which may be mainstream banks. Due in part to their specialized structure, shadow banks can sometimes provide credit more cost-efficiently than traditional banks. A headline study by the International Monetary Fund defines the two key functions of the shadow banking system as securitization – to create safe assets, and collateral intermediation – to help reduce counterparty risks and facilitate secured transactions. In the US, before the 2008 financial crisis, the shadow banking system had overtaken the regular banking system in supplying loans to various types of borrower; including businesses, home and car buyers, students and credit users. As they are often less risk averse than regular banks, entities from the shadow banking system will sometimes provide loans to borrowers who might otherwise be refused credit. Money market funds are considered more risk averse than regular banks and thus lack this risk characteristic.


Risks associated with shadow banking

Leverage (the means by which banks multiply and spread risk) is considered to be a key risk feature of shadow banks, as well as traditional banks. Money market funds are completely unleveraged and thus do not have this risk characteristic.


Recent attempts to regulate the shadow banking system

The recommendations for G20 leaders on regulating shadow banks were due to be finalised by the end of 2012. The United States and the European Union are already considering rules to increase regulation of areas like securitisation and money market funds, although the need for money market fund reforms has been questioned in the United States in light of reforms adopted by the Securities and Exchange Commission in 2010. The International Monetary Fund suggested that the two policy priorities should be to reduce spillovers from the shadow banking system to the main
banking system A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Becaus ...
and to reduce procyclicality and systemic risk within the shadow banking system itself. The G20 leaders meeting in Russia in September 2013, will endorse the new Financial Stability Board (FSB) global regulations for the shadow banking systems which will come into effect by 2015.


Importance

Many "shadow bank"-like institutions and vehicles have emerged in American and European markets, between the years 2000 and 2008, and have come to play an important role in providing credit across the global financial system. Tett, Gillian, and Davies, Paul J.
Out of the shadows: How banking’s secret system broke down
, ''The Financial Times'', ft.com, 2007-12-16, 18:33.
In a June 2008 speech,
Timothy Geithner Timothy Franz Geithner (; born August 18, 1961) is a former American central banker who served as the 75th United States Secretary of the Treasury under President Barack Obama from 2009 to 2013. He was the President of the Federal Reserve Bank ...
, then president and CEO of the Federal Reserve Bank of New York, described the growing importance of what he called the "non-bank financial system": "In early 2007,
asset-backed commercial paper Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. Institutional investors usually purchase such instruments in order to diversify their assets and generate short-term gains. Str ...
conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate
demand notes A Demand Note is a type of United States paper money that was issued between August 1861 and April 1862 during the American Civil War in denominations of 5, 10, and 20 . Demand Notes were the first issue of paper money by the United States ...
, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five
bank holding companies A bank holding company is a company that controls one or more banks, but does not necessarily engage in banking itself. The compound bancorp (''banc''/''bank'' + '' corp ration') is often used to refer to these companies as well. United States ...
in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion."Geithner, Timothy
Reducing Systemic Risk in a Dynamic Financial System
, speech transcript, delivered 2008-6-9, The Economic Club of New York, New York City, via newyorkfed.org. The term "shadow" appears nowhere in transcript.
In 2016, Benoît Cœuré ( ECB executive board member) stated that controlling shadow banking should be the focus to avoid a future financial crisis, since the banks' leverage had been lowered.


Risks or vulnerability

Shadow institutions are not subject to the same prudential regulations as depository banks, so that they do not have to keep as high financial reserves relative to their market exposure. Thus they can have a very high level of financial leverage, with a high ratio of debt relative to the liquid assets available to pay immediate claims. High leverage magnifies profits during boom periods and losses during downturns. This high leverage will also not be readily apparent to investors, and shadow institutions may therefore be able to create the appearance of superior performance during boom times by simply taking greater pro-cyclical risks. Money market funds have zero leverage and thus do not pose this risk feature of shadow banks. Shadow institutions like ''SIVs'' and ''conduits'', typically sponsored and guaranteed by commercial banks, borrowed from investors in short-term, liquid markets (such as the money market and
commercial paper Commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity of rarely more than 270 days. In layperson terms, it is like an "IOU" but can be bought and sold because its buyers and sellers have some ...
markets), so that they would have to repay and borrow again from these investors at frequent intervals. On the other hand, they used the funds to lend to corporations or to invest in longer-term, less liquid (i.e. harder to sell) assets. In many cases, the long-term assets purchased were mortgage-backed securities, sometimes called "toxic assets" or "legacy assets" in the press. These assets declined significantly in value as housing prices declined and foreclosures increased during 2007–2009. In the case of investment banks, this reliance on short-term financing required them to return frequently to investors in the
capital markets A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are bought and sold, in contrast to a money market where short-term debt is bought and sold. Capital markets channel the wealth of savers t ...
to refinance their operations. When the housing market began to deteriorate and their ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks could not refinance themselves. Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of
Bear Stearns The Bear Stearns Companies, Inc. was a New York-based global investment bank, securities trading and brokerage firm that failed in 2008 as part of the global financial crisis and recession, and was subsequently sold to JPMorgan Chase. The com ...
and Lehman Brothers during 2008. From a technical standpoint, these institutions are subject to
market risk Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility. There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the mos ...
,
credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
and especially liquidity risk, since their liabilities are short term while their assets are more long term and illiquid. This creates a problem, as they are not depositary institutions and do not have direct or indirect access to the support of their central bank in its role as lender of last resort. Therefore, during periods of market illiquidity, they could go bankrupt if unable to refinance their short-term liabilities. They were also highly leveraged. This meant that disruptions in credit markets would make them subject to rapid deleveraging, meaning they would have to pay off their debts by selling their long-term assets. A sell off of assets could cause further price declines of those assets and further losses and selloffs. In contrast to investment banks, money market funds do not go bankrupt—they distribute their assets (which are mainly short-term) pro rata to shareholders if their net asset value falls below $.9995 per share. Only two funds ever have failed to pay investors $1.00 per share. The Reserve Primary Fund paid $.99 per share to its shareholders and another fund paid its shareholders $.96 per share in 1994. The securitization markets frequently tapped by the shadow banking system started to close down in the spring of 2007, with the first failure of auction-rate offerings to attract bids. As excesses associated with the U.S. housing bubble became widely understood and borrower default rates rose, residential mortgage-backed securities (RMBS) deflated. Tranched
collateralized debt obligation A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).Lepke ...
s (CDOs) lost value as default rates increased beyond the levels projected by their associated agency
credit rating A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting. ...
s. Commercial mortgage-backed securities suffered from association and from a general decline in economic activity, and the entire complex nearly shut down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds. In February 2009,
Ben Bernanke Ben Shalom Bernanke ( ; born December 13, 1953) is an American economist who served as the 14th chairman of the Federal Reserve from 2006 to 2014. After leaving the Fed, he was appointed a distinguished fellow at the Brookings Institution. Duri ...
stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.
U.S. Treasury The Department of the Treasury (USDT) is the national treasury and finance department of the federal government of the United States, where it serves as an executive department. The department oversees the Bureau of Engraving and Printing and t ...
Secretary Timothy Geithner has stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles." In January 2012, the global Financial Stability Board announced its intention to further regulate the shadow banking system, in the interests of the real economy.


History and origin of the term

The term "shadow banking system" is attributed to
Paul McCulley Paul Allen McCulley (born March 13, 1957) is an American economist and former managing director at PIMCO. He coined the terms "Minsky moment" and "shadow banking system", which became famous during the Financial crisis of 2007–2009. He is curre ...
of PIMCO, who coined it at
Federal Reserve Bank of Kansas City The Federal Reserve Bank of Kansas City is located in Kansas City, Missouri and covers the 10th District of the Federal Reserve, which includes Colorado, Kansas, Nebraska, Oklahoma, Wyoming, and portions of western Missouri and northern Ne ...
's Economic Symposium in
Jackson Hole Jackson Hole (originally called Jackson's Hole by mountain men) is a valley between the Gros Ventre and Teton mountain ranges in the U.S. state of Wyoming, near the border with Idaho, in Teton County, one of the richest counties in the Unite ...
, Wyoming in 2007 where he defined it as "the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures." McCulley identified the birth of the shadow banking system with the development of money market funds in the 1970s – money market accounts function largely as bank deposits, but money market funds are not regulated as banks. The concept of hidden high priority debt dates back at least 400 years to ''
Twyne's Case ''Twyne's case'' (1601) 76 ER 809; 3 Co. Rep. 80b is a UK insolvency law case, concerning a fraudulent conveyance. Representative of earlier English law, it was considered that any transfer of property from a debtor to a creditor, after which ...
'' and the
Statute of Bankrupts The Statute of Bankrupts or An Acte againste suche persones as doo make Bankrupte, 34 & 35 Henry VIII, c. 4, was an Act passed by the Parliament of England in 1542. It was the first statute under English law dealing with bankruptcy or insolvenc ...
(1542) in the UK, and to ''Clow v. Woods'' in the U.S. These legal cases led to the development of modern
fraudulent transfer A fraudulent conveyance, or fraudulent transfer, is an attempt to avoid debt by transferring money to another person or company. It is generally a civil, not a criminal matter, meaning that one cannot go to jail for it, but in some jurisdictions th ...
law. The concept of credit growth by unregulated institutions, though not the term "shadow banking system", dates at least to 1935, when
Friedrich Hayek Friedrich August von Hayek ( , ; 8 May 189923 March 1992), often referred to by his initials F. A. Hayek, was an Austrian–British economist, legal theorist and philosopher who is best known for his defense of classical liberalism. Haye ...
stated: The full extent of the shadow banking system was not widely recognised until work was published in 2010 by Manmohan Singh and James Aitken of the International Monetary Fund, showing that when the role of
rehypothecation Hypothec (; german: Hypothek, french: hypothèque, pl, hipoteka, from Lat. ''hypotheca'', from Gk. : hypothēkē), sometimes tacit hypothec, is a term used in civil law systems (e.g. law of entire Continental Europe except Gibraltar) or mixed ...
was considered, in the U.S. the SBS had grown to over $10 trillion, about twice as much as previous estimates.Singh, Manmohan, and Aitken, James
The (sizable) Role of Rehypothecation in the Shadow Banking System
, International Monetary Fund, imf.org, 2010-07-01. Accessed 2010-08-31.
Tett, Gillian

, ''The Financial Times'', ft.com, 2010-08-12. Accessed 2010-08-31.


Examples

During 1998, the highly leveraged and unregulated hedge fund Long-Term Capital Management failed and was bailed out by several major banks at the request of the government, which was concerned about possible damage to the broader financial system.
Structured investment vehicles A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, ...
(SIVs) first came to public attention at the time of the Enron scandal. Since then, their use has become widespread in the financial world. In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off their balance sheets into special purpose vehicles (SPEs) or similar entities. This enabled them to bypass regulatory requirements for minimum
capital adequacy ratio Capital Adequacy Ratio (CAR) is also known as ''Capital to Risk (Weighted) Assets Ratio'' (CRAR), is the ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and com ...
s, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance was planned to require them to put some of these assets back onto their books during 2009, with the effect of reducing their capital ratios. One news agency estimated the amount of assets to be transferred at between $500 billion and $1 trillion. This transfer was considered as part of the stress tests performed by the government during 2009.


Credit derivatives facilitate extension of credit

The shadow banking system also conducts an enormous amount of trading activity in the
over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid prescr ...
(OTC) derivatives market, which grew rapidly in the decade up to the 2008 financial crisis, reaching over US$650 trillion in notional contracts traded. BIS
Credit Risk Transfer Developments from 2005 to 2007
, The Joint Forum, Bank for International Settlements, bis.org, 2008-7-31. Accessed 2012-4-30.
This rapid growth mainly arose from
credit derivative In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the ''credit risk''"The Economist ''Passing on the risks'' 2 November 1996 or the risk of an event of default of a corp ...
s. In particular these included: * interest rate obligations derived from bundles of mortgage securities * collateralised debt obligations (CDO) * credit default swaps (CDS), a form of insurance against the default risk inherent in the assets underlying a CDO; and * a variety of customized innovations on the CDO model, collectively known as
synthetic CDO A synthetic CDO (collateralized debt obligation) is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals.Lemke, Lins and Picard, ''Mortgage-Backed Securities'', §5:16 (Thomson West, 2017 ...
s The market in CDS, for example, was insignificant in 2004 but rose to over $60 trillion in a few years. Because credit default swaps were not regulated as insurance contracts, companies selling them were not required to maintain sufficient capital reserves to pay potential claims. Demands for settlement of hundreds of billions of dollars of credit default swaps contracts issued by
AIG American International Group, Inc. (AIG) is an American multinational finance and insurance corporation with operations in more than 80 countries and jurisdictions. , AIG companies employed 49,600 people.https://www.aig.com/content/dam/aig/amer ...
, the largest
insurance company Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
in the world, led to its financial collapse. Despite the prevalence and volume of this activity, it attracted little outside attention before 2007, and much of it was off the balance sheets of the contracting parties' affiliated banks. The uncertainty this created among counterparties contributed to the deterioration of credit conditions. Since then the shadow banking system has been blamed for aggravating the subprime mortgage crisis and helping to transform it into a global
credit crunch A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit cr ...
.


Contribution to the 2007–2012 financial crisis

The shadow banking system has been implicated as significantly contributing to the global financial crisis of 2007–2012. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the New York Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the shadow banking system by their counterparties. The rapid increase of the dependency of bank and non-bank financial institutions on the use of these off-balance sheet entities to fund investment strategies had made them critical to the credit markets underpinning the financial system as a whole, despite their existence in the shadows, outside of the regulatory controls governing commercial banking activity. Furthermore, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices. Economist Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."Lambin, J., ''Rethinking the Market Economy: New Challenges, New Ideas, New Opportunities'' (London: Palgrave Macmillan, 2014)
p. 21
One former banking regulator has said that regulated banking organizations are the largest shadow banks and that shadow banking activities within the regulated banking system were responsible for the severity of the financial crisis.


See also

* Irish Section 110 Special Purpose Vehicle (SPV) * Long-Term Capital Management * Recession *
Structured investment vehicle A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, ...
* Subprime mortgage crisis * Subprime crisis background information *
Subprime mortgage crisis solutions debate The Subprime mortgage crisis solutions debate discusses various actions and proposals by economists, government officials, journalists, and business leaders to address the subprime mortgage crisis and broader financial crisis of 2007–08. Overv ...
*
Shadow government (conspiracy theory) The shadow government (cryptocracy, secret government, or invisible government) is a family of theories based on the notion that real and actual political power resides not only with publicly elected representatives but with private individuals ...


Notes and references


External links


IMF report, 2014

Shadow Banking
2010 report (revised 2012) on the SBS from the Federal Reserve Bank of New York with a detailed diagram of the system. {{Authority control Banking United States housing bubble Pejorative terms