The Shadow Banking System: What is it, What it Does, and How it Works

What Is the Shadow Banking System?

The shadow banking system is a group of financial intermediaries that facilitate credit creation across the global financial system but are not subject to regulatory oversight. These companies are often known as nonbank financial companies (NBFCs). The shadow banking system also refers to unregulated activities by regulated institutions.

Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives, and other unlisted instruments, while examples of unregulated activities by regulated institutions include credit default swaps.

Understanding Shadow Banking Systems

Most of the shadow-banking sector is made up of NBFCs, which fall under the oversight of the Dodd-Frank Wall Street Reform and Consumer Protection Act. NBFCs existed long before the Dodd-Frank Act. In 2007, they were given the moniker “shadow banks” by economist Paul McCulley, at the time the managing director of Pacific Investment Management Company LLC (PIMCO), to describe the expanding matrix of institutions contributing to the then-current easy-money lending environment—which in turn led to the subprime mortgage meltdown and the subsequent 2008 financial crisis.1

Although the term "shadow banking" sounds somewhat sinister, many well-known brokerages and investment firms engage in shadow-banking activity. Investment bankers Lehman Brothers and Bear Stearns were two of the more famed NBFCs at the center of the 2008 financial crisis.2

As a result of that crisis, traditional banks found themselves under closer regulatory scrutiny, which led to a prolonged contraction in their lending activities. As the authorities tightened up on the banks, the banks, in turn, tightened up on loan or credit applicants. The more stringent requirements gave rise to more people needing other funding sources—and hence, the growth of nonbank, "shadow" institutions that were able to operate outside the constraints of banking regulations.

The Breadth of the Shadow Banking System

The shadow banking system has escaped regulation primarily because unlike traditional banks and credit unions, these institutions do not accept traditional deposits. Generally, these institutions are not allowed to take traditional demand deposits—readily available funds, such as those in checking or savings accounts—from the public. This limitation keeps them outside the scope of conventional oversight from federal and state financial regulators.

Shadow banking institutions arose as innovators in financial markets who were able to finance lending for real estate and other purposes but who did not face the normal regulatory oversight and rules regarding capital reserves and liquidity that are required of traditional lenders in order to help prevent bank failures, runs on banks, and financial crises. As a result, many of the institutions and instruments have been able to pursue higher market, credit, and liquidity risks in their lending and do not have capital requirements commensurate with those risks.

In the decade following the financial crisis of 2007-08, the shadow-banking sector expanded, playing a key role in meeting the credit demand unmet by traditional banks.

Despite the higher level of scrutiny of shadow banking institutions in the wake of the financial crisis, the sector has grown significantly. According to the Financial Stability Board, the assets held by NBFCs grew by 7.4% to $63.2 trillion in 2020, at a pace similar to the 2014-19 annual growth rate of 7.3%. At end-2020, it therefore represented 27.9% of total NBFC assets and 13.7% of total global financial assets. Since the 2008 financial crisis, growth of the narrow measure has been driven primarily by investment funds.

Who Is Watching the Shadow Banks?

The shadow banking industry plays a critical role in meeting rising credit demand in the United States. Although it's been argued that shadow banking's disintermediation can increase economic efficiency, its operation outside of traditional banking regulations raises concerns over the systemic risk it may pose to the financial system.

The reforms enacted through the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act focused primarily on the banking industry, leaving the shadow banking sector largely intact. While the Act imposed greater liability on financial companies selling exotic financial products, most of the non-banking activities are still unregulated. The Federal Reserve Board has proposed that nonbanks, such as broker-dealers, operate under similar margin requirements as banks. Meanwhile, outside the United States, China began issuing directives in 2016 directly targeting risky financial practices such as excessive borrowing and speculation in equities.

What Are Examples of Shadow Banks?

Plenty of well-known companies are counted as shadow banks. These include:

• Investment banks, like Goldman Sachs or Morgan Stanley
• Mortgage lenders
• Money market funds

• Insurance/re-insurance companies

What Are the Benefits of Shadow Banking?

Its supporters argue that an advantage of shadow banking is that it reduces the dependency on traditional banks as a source of credit. This is a positive benefit for the economy because it acts as an additional source of lending and provides diversification in the financial system.

Should Shadow Banks Be Regulated?

Many institutions, including the European Commission, argue that they should. They argue that the shadow banking sector requires regulation because of its size (25% to 30% of the total financial system), its close links to the regulated financial sector, and the systemic risks that it poses. There is also a need, they claim, to prevent the shadow banking system from being used for regulatory arbitrage.

The Bottom Line

The shadow banking system consists of lenders, brokers, and other credit intermediaries who fall outside the realm of traditional regulated banking. Although the term "shadow banking" sounds somewhat sinister, many well-known brokerages and investment firms engage in shadow-banking activity.

Proponents of these firms argue that they provide necessary credit that is not available through traditional banking channels. Opponents say that the shadow-banking sector is an unregulated risk to consumers and to the financial security of the US economy.

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