Shadow Banking System: Ready to Blow Again?

Jul. 14, 2010 4:19 AM ETXLF, KBE, KRE4 Comments

The shadow banking system is essentially the world of financial companies who don't have access to central bank liquidity or government guarantees such as normal banks, but who provide bank-like services.

It grew to be larger than the normal banking system itself pre-crisis, as U.S. financial innovation ran rampant, and then contracted particularly hard during the crisis since these 'non-bank banks' didn't have the kind of government backstops banks do. For example, normal retail banks have FDIC guarantees for their average retail customers' deposits, which prevent banking runs during times of panic. Financial companies in the shadow banking system have nothing like this and it showed them to be particularly unstable during the crisis.

Well, a new research paper from the New York Fed shows how despite its contraction, the shadow banking system remains larger than the traditional one, with $16 trillion vs. $13 trillion in assets.


It's like a giant pile of dry powder still lying around, ready to blow up during the next financial crisis. From The Economist:

The subprime crisis may have started the fall, but the financial crisis was precipitated by a run on shadow banks. As this paper shows, there is an inherent weakness in the shadow banking system that makes it vulnerable to future bank runs.

For shadow banks, the bulk of the deposits are provided by money market funds. These funds expect their deposits to be available on demand and at par. But the implicit put option, at par value, is not backed up by any capital or official enhancement whatsoever.

From the perspective of the shadow banks, their funding sources are not as stable as retail cash balances. As the authors point out, institutional cash balances, such as those of corporations and municipalities, are well-informed but exhibit herd-like characteristics. Any entity that relies on them for funding and lacks alternative sources of liquidity is inherently fragile. During times of crisis, if confidence in the credit puts guaranteed by the institutions erodes, depositors move to redeem their funds. Absent a backstop, in the form of government guarantees, a run on the system ensues.

So basically, we haven't changed much. Our financial system remains vulnerable to another credit crunch, with many of the same exact features as the last. All it needs is someone to strike the match of panic.

The hard question is how to deal with the chart above. Regulate shadow banking more tightly, and you probably have to also provide government backstops. Shudder. Try to shut the thing down or restrict it and you suck credit out of the system, credit which much of the non-financial 'real' economy uses and needs.

So it's clearly not an easy situation, and somehow I feel that we'll all just sit and do nothing since hard decisions usually end that way. Even the New York Fed paper referred to above says that it doesn't want to take a position on the regulatory issue. Everyone's on the fence, watching the powder dry.

You can find the full Fed research paper here.

Disclosure: No positions

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