Shadow Banking System: A Massive Yet Little Known Part of the Economy

Table of Contents

shadow banking system

What is Shadow Banking?

A shadow banking system refers to:

  1. a collection of unregulated or minimally regulated non-bank financial intermediaries (NBFI) that facilitate the creation of credit throughout the global financial system (e.g. hedge funds)
  2. Unregulated activities by regulated financial institutions (e.g. credit default swaps)

The G20 regulatory task force Financial Stability Board (FSB) published a 2019 report on shadow banking covering data from 29 juridisticions, representing over 80% of the global GDP. 

MUNFI (Monitoring Universe of Non-Bank Financial Intermediation) serves as the umbrella category including all forms of NBFI. It comes in at $184 trillion of the $379 trillion (48%) in total global GDP. The FSB’s ‘narrow measure’ of NBFI, a.k.a. shadow banking that poses the greatest threat to economic stability, “grew by 1.7%, to $50.9 trillion in 2018, compared to an average annual growth rate of 8.5% from 2012 to 17. It now represents 13.6% of total global financial assets.”


Economist Paul McCulley coined the term ‘shadow banking’ in 2007, at the Federal Reserve’s annual symposium in Jackson Hole, Wyoming. 

How does the Shadow Banking System Work?

Shadow banks perform the same essential functions as conventional financial institutions do—granted, in their own way. They facilitate money transfers from lenders to borrowers, or in other words, provide credit and liquidity. 

But the lack of safety measures (e.g. deposit insurance) and access to central bank funding differentiate the shadow banking system from the traditional banking system.

Deeper Explanation

Instead of receiving deposits like traditional financial institutions, the shadow banking system operates on short-term funding from asset-backed commercial paper (ABCP) or by the repo market.

Shadow banks commonly target long-term investments, such as mortgages. The loan originator sells the loans to another financial institution, which pools the loans together to create a single product or security. In essence, underlying loan payments get put together and sold as a package deal.

Did you know AIG played a major role in the 2008 financial crisis? 

See what your fellow citizens have uncovered on the Zero Theft Movement platform…

Why is the Shadow Banking System so large? 

The shadow banking system, as the numbers indicate, plays a major role in the global economy. It’s 48% of the total financial system, according to the FSB.

Why does it account for so much of the global economy? 

Well, for one, it actually provides funding to traditional financial institutions. This allows traditional banks to invest and lend more, stimulating the economy. Shadow banks invest in long-term loans like mortgages, providing 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.

Furthermore, as shadow banks do not experience much regulatory oversight, they can freely take on much more risk than traditional banks can. That’s how companies, individuals, etc. who have less-than-ideal credit histories can still get loans. 

This willingness to assume risk, even high risk without any safety net or restrictions, has majorly contributed to global financial crises, which we’ll discuss a bit later.


Because of its lack of regulation, the shadow banking system has deep ties to shell companies and tax havens.

Past Regulation (or lack thereof) of Shadow Banks

The Federal Reserve of New York’s staff reporters wrote about the reputation of the shadow banking system prior to the 2008 financial crisis: “The securitization and funding techniques that underpin shadow banking were widely acclaimed as financial innovations to achieve credit risk transfer and were commonly linked to the stability of the financial system and the real economy.”

Shadow banking opened up financial lending for real estate and other purposes because it did not have the regulations regarding capital reserves and liquidity that traditional financial lenders must abide by. As explained in the report linked above, the shadow banking system ignited subprime mortgage lending and loan securitization in the early 2000’s.

shadow market caused housing bubble (1)

From The New York Times

The Shadow Banking System and the 2008 Mortgage Crisis

The restrictions, as you might have already realized, are there to reduce risk, prevent bank failures, runs on banks, and financial crises. The shadow banking system generated great returns for a period, but its abuse and lack of regulations ultimately contributed to the near-collapse of the global economy. 

In 2009, the aforementioned McCulley wrote about the shadow banking practices that led to the rise and fall of the housing market: “[Bankers raised funds] in the non-deposit markets, notably unsecured debt such as interbank borrowing and commercial paper, and secured borrowing such as reverse repo and asset-backed commercial paper. And usually– but not always–such shadow banks maintained a reliance on conventional banks with access to the Fed’s window.”

But with all these debts packaged in securities, a financial skein had been created.

Investors operated on the assumption that these securities were safe because they often came with a AAA rating. The high risk loans that were given out due to a lack of regulation were not accurately reflected in those ratings. So once the quality of these investments actually came into question, the whole shadow banking system quickly began crumbling.

Gary Gorton, in his much-cited paper “Regulating the Shadow Banking System,” argues that a run on the shadow banks’ short-term funding (particularly a run on the repo market) caused the 2008 mortgage crisis: “The panic occurred when depositors in repo transactions with banks feared that the banks might fail and they would have to sell the collateral in the market to recover their money, possibly at a loss given that so much collateral was being sold at once. In reaction, investors increased repo haircuts.”

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Let’s say a bond worth $100 was completely financed in the repo market without any haircut. But because of the impending crisis, the haircut increased from 0 to 20 percent. The owner of the bond would have to find a way to finance that 20% or $20. In the case no one will give them a loan or a new security, the owner has to sell assets to pay the haircut.

The increased haircuts essentially caused ‘deleveraging,’ where people were selling off all kinds of assets at much lower prices because they could not get any loans or new securities. This huge drop in numerous asset classes brought the global economy to near ruin. 

The Aftermath

Hoping to prevent future crises involving shadow banking, Congress passed the Dodd-Frank Act, establishing the Financial Security Oversight Council to oversee the ongoings in shadow banking. The bill also put into place regulations particularly for hedge funds. 

But according to Gorton, there are significant regulatory gaps for MMMFs, securitization, and repos. Former Fed Chair Janet Yellen was recently quoted as saying, “We need a new Dodd-Frank.”

But on a personal level, countless people around the globe experienced emotional and monetary damages that some have yet to rebound from. After all that, those who kept on making these risky investments got bailed out with taxpayer money. Even worse, the New York Times reported that  “Nine of the financial firms that were among the largest recipients of federal bailout money paid about 5,000 of their traders and bankers bonuses of more than $1 million apiece for 2008…”

The Shadow Banking System, is it used to unethically profit? 

From FSB’s numbers, shadow banking has steadily risen since the 2008 financial crisis. It was going strong without a doubt, but the COVID-19 might be derailing the upward trend. 

The Wall Street Journal’s Jon Sindreu believes that the virus might bring about a transformation of shadow banking. Sindreu cites investment giant Apollo Global Management and its announcement of its $12 billion platform that will make loans of around $1 billion. This move to “direct lending”—where funds (which do not have such strict regulations) assume the role of banks by providing loans to firms—is a sign of things to come, according to Sindreu. He writes that the shadow banking system is “expanding beyond its middle-market niche toward funding big companies.”

Do you believe the shadow banking system needs better regulation? Do you think the lack of oversight caused significant losses for the American public?

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Beyond the Shadow Banking System…

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