Research Paper: Shadow Banking System, Its Role

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[. . .] The shadow banking system, which is believed to be at least equal in size to the traditional banking system, also affects the money supply. If the shadow banking system slows down its lending, the money supply is likewise affected. With the shadow banking system's reliance on ultra-safe collateral, the less collateral that there is, the less new debt the system creates (Drum, 2012).

A 2012 Credit Suisse report shows an expansion of public shadow money since 2008, which offset the contraction in private shadow money, that is, corporate bonds, asset-backed securities, and non-agency mortgages. Credit Suisse expects private shadow money to further contract in 2012. This prediction leads some analysts to conclude that the economy is unlikely to face significant inflationary pressure until the total money supply, both public and private, returns to pre-crisis trend levels. This conclusion leads to an argument against tightening fiscal policy too quickly, given that fiscal consolidation tightens monetary policy also. Therefore, the shadow banking system's effect on money supply needs to be factored into any public policy discussion (Drum, 2012).

The Future of Shadow Banking

Regulators have proposed a number of solutions to control shadow banking. One such solution would require institutions that most closely resemble banks, such as money market funds, to be regulated as such. Other proposed changes call for regulation to be done on asset classes as opposed to institutions. This change would result in minimum capital requirements, such as haircuts and loan-to-value ratios, being imposed on the lending of certain securities without regard to the parties involved. Central bankers and regulators would also like greater powers to shift the scope of regulation more quickly in the future, allowing them to impose rules to influence risky behavior beyond the usual scope of their responsibility (Armstrong, 2010).

Another proposal for regulating the shadow banking system involves establishing the "credit insurer of last resort." The proposal updates the Bagehot Rule, which dates back to 1873, to state "Insure freely, but at a high premium" (as quoted by Konczal, 2009). This recommendation is based up the argument that when AIG sold systemic risk insurance for 15 basis points, the price was too low. As a result people reasoned that if they could get rid of the whole tail risk that cheaply, they should load up and take more systemic risk. Rather, the price of risk insurance should be raised to a reasonable rate that will achieve adequate credit insurance (Konczal, 2009).

One significant challenge for shadow banking reform involves the Federal Reserve creating liquidity programs to unthaw the repo market is the problem of moral hazard. This form of government intervention was shown to work during the 2007-2008 financial crisis, thereby creating the expectation that it will be used again if needed. This form of "deposit insurance" for the shadow banking system is expected to create moral hazard problems that will result in the need for even more government regulation (Beckworth, 2010).

Ricks (2010) makes a similar argument, proposing that instead of expanding the safety net to cover shadow banking and increasing the likelihood of moral hazard, the net should contract. By extending the safety net to include shadow banking, the government's explicit commitments to the financial system would vastly expand. Given that safety nets encourage risky behavior, this approach would give rise to inefficient resource allocation and further burden taxpayers once insurance funds are exhausted. A further extension of this line of reasoning implies that, rather than expanding the safety net, a better solution would be found in reinforcing market discipline by short-term creditors of shadow banking firms.

Some experts point with alarm to the fact that the shadow banking system enjoyed a faster recovery than the traditional banking system, which even received massive capital injections from taxpayers. Given that the traditional banking industry is facing new more stringent capital requirements, the result is that shadow banking competition is shrinking, and their clients are in need of new sources of debt. These circumstances amount to creating a perfect environment in which shadow banking can thrive (Spanos, 2012). For anyone who believes that shadow banking contributed to the severity of the recent global financial crisis, the alarm bells are sounding. Another critic points out that "Financial system instability is no accident. It's central bank policy" (Whitney, 2010), arguing that financial institutions continue to rely on "dodgy accounting, bogus ratings, opaque debt-instruments, high-frequency trading and lax lending standards."


Given the amount of time that has elapsed since the subprime mortgage crisis, the shadow banking industry gets mixed reviews on making progress toward fixing the problems that the crisis exposed. One of the issues that the subprime mortgage meltdown exposed was that few institutions or regulators actually understood the complexities of many securitized financial products. Because they were not well understood, their risk was underestimated, which in turn led to an inability to respond to bank runs. Almost no one was prepared for the spread of contagion and the resulting liquidity crisis.

Some lessons were apparently learned, such as the need to take shadow banking problems seriously and allow for greater transparency and visibility into shadow banking vulnerabilities. Fed Chairman Ben Bernanke acknowledged as much in a recent speech, saying that the Fed is "keeping its eyes closely on it" and that he wants to spot the "vulnerabilities of the system" (as quoted by Mullan, 2012). I do not find his remarks particularly reassuring, given that such reforms typically are slow in coming and do not go far enough when finally implemented.

Two such examples include FASB rules intended to limit banks' ability to park assets off their balance sheets, as well as Dodd-Frank Act provisions that require some institutions to be designated as "systemically important financial institutions" or SIFIs, marking them for closer scrutiny and supervision. Neither the SEC nor the Justice Department has shown any tendency to aggressively enforce such legislation in the past.

The most concerning conclusion regarding shadow banking is that, in many ways the system will carry on with business as usual, with the very real possibility that another system-wide financial crisis can occur. To date, there has not been enough real progress in eliminating the vulnerabilities of shadow banking and it remains to be seen whether more effective reforms will be forthcoming.

Reference List

Armstrong, R., 2010. Q+A -- Regulating the shadow banking system. Fox Business. [online] Available at: [Accessed 20 April 2012].

Beckworth, D., 2010. "Deposit insurance" for the shadow banking system. [online] Available at: [Accessed 20 April 2012].

Drum, K., 2012. The shadow banking system speaks: It's not time for austerity yet. MotherJones. [online] Available at: [Accessed 20 April 2012].

Hsu, J. And Moroz, M., 2009. Shadow banks and the financial crisis of 2007-2008. Research Affiliates LLC. [online] Available at: [Accessed 20 April 2012].

Investopedia, 2012. Shadow banking system definition. [online] Available at: [Accessed 20 April 2012].

Klein, E., 2010. Explaining FinReg: Shadow bank runs, or the problem behind the problem. The Washington Post. [online] Available at: [Accessed 20 April 2012].

Konczal, M., 2009. Shadow banking: What it is, how it broke, and how to fix it. The Atlantic. [blog] Available at: [Accessed 20 April 2012].

Mullan, S., 2012. Bernanke Q&A: Still need to watch shadow banking problems. Forex Live. [online] Available at: [Accessed 20 April 2012].

Noeth, B.J., and Sengupta, R., 2011. Is shadow banking really banking? Federal Reserve bank of St. Louis. [online] Available at: [Accessed 20 April 2012].

Pozsar, Z., Adrian, T., Ashcraft, A., and Boesky, H., 2012. Shadow banking. Federal Reserve Bank of New York. [online] Available at: [Accessed 20 April 2012].

Ricks, M., 2010. Shadow banking and financial regulation. Harvard Law School Forum on Corporate Governance and Financial Regulation. [online] Available at: [Accessed 20 April 2012].

Spanos, C.N., 2012. Beware the rebirth of the shadow banking system. Seeking Alpha. [online] Available at: [Accessed 20 April 2012].

Stein, J., 2010. Securitization, shadow banking, and financial fragility. Harvard University. [online] Available at: [Accessed 20 April 2012].

Whitney, M., 2010. Shadow banking makes a comeback. [online] Available at: [Accessed 20 April 2012]. [END OF PREVIEW]

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APA Format

Shadow Banking System, Its Role.  (2012, April 21).  Retrieved June 18, 2019, from

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"Shadow Banking System, Its Role."  21 April 2012.  Web.  18 June 2019. <>.

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"Shadow Banking System, Its Role."  April 21, 2012.  Accessed June 18, 2019.