What is the Shadow Banking System?
The shadow banking system is the broad collection of financial institutions and financial markets that offer the same type of services as commercial banks but that are not within the regulatory environment that traditional banks are subject to.
Elements of the shadow banking system include mortgage lending companies, repurchase agreements, asset-backed commercial paper, hedge funds, credit insurance providers, structured investment vehicles, and money market funds.
The shadow banking system has expanded tremendously in the 21st century. As of 2019, it was estimated to constitute an industry wherein the total asset value exceeds $100 trillion, and more than 80% of all loans to corporations are provided by shadow banking entities.
- The shadow banking system is composed of a wide variety of companies and financial markets that provide lending and investing services similar to those offered by commercial banks, but that operate outside of the regulatory framework that governs the banking industry.
- Shadow banking has grown exponentially since the turn of the century.
- Shadow banking operations garnered much of the blame for the 2008 Global Financial Crisis.
The Shadow Bank Industry
The phrase “shadow banking” was originally coined by Paul McCulley, chief economist for investment management company PIMCO, in 2007. The shadow banking industry, although it operates outside of the heavily regulated venue of regular commercial banking, is closely associated with the overall banking industry.
In fact, many shadow banking companies are subsidiary companies whose parent company is a traditional bank.
What differentiates shadow banking activities from traditional banking is that shadow banking companies are not depository institutions – i.e., they do not accept and hold deposits from ordinary consumers – which exempts them from the government regulation and oversight that governs regular commercial banks.
The term “shadow” is used to describe the fact that, since they are exempt from government regulation, the operations of companies in the shadow banking system are not transparent to the public in the way that regular banks’ operations are.
Shadow banking companies are often set up to act as a sort of middleman between borrowers and investors. A good example is a private equity fund that gathers large sums of money from investors and then loans the money collected to companies.
The shadow bank industry is heavily involved in the business of securitization and the financial derivatives markets. The process involves the repackaging of various types of debt, such as mortgages or credit card debt, into financial securities such as asset-backed mortgages (ABMs) and credit default swaps that are sold to investors.
A prime example of a business in the shadow banking system is a peer-to-peer (P2P) lending business, such as Prosper.com. P2P businesses connect investors and borrowers through online platforms. They earn money by charging loan origination fees, among other fees.
The peer-to-peer lending business has been rapidly growing and changing. It was originally envisioned to pool lending capital from many small investors, which could then be loaned out to borrowers.
However, the success of the industry has attracted hedge funds and institutional investors, such as pension funds, which means that much of the money flowing through peer-to-peer lending companies is now coming from large, rather than small, investors.
Shadow Banking and the 2008 Global Financial Crisis
The shadow banking industry is viewed as heavily contributing to the housing market collapse and the worldwide financial crisis that began in 2008. Many companies in the industry, especially mortgage lending companies, had become severely overextended through their lending practices.
Again, it occurred in part because shadow banking companies are not subject to the same regulations – such as reserve requirements – that regular commercial banks are constrained by. Therefore, they are able to operate with higher levels of liquidity risk and credit risk compared to traditional bank lenders.
Much of what precipitated the financial crisis, leading to the eventual collapse of major financial firms such as Lehman Brothers, originated with derivative securities that were comprised of mortgage loans.
The securities were sold with credit ratings that did not accurately reflect the true level of credit risk – which was actually much lower – presented by many of the individual mortgage loans that made up the securities.
The financial crisis brought to light the fact that investment banks, while their primary operations are subject to government regulation, conduct major portions of their business through off-balance sheet transactions such as credit default swaps.
CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: