The shadow banking system or the shadow financial system consists of non-depository banks and other financial entities (e.g., investment banks, hedge funds, and money market funds) that grew in size dramatically after the year 2000 and play an increasingly critical role in lending businesses the money necessary to operate. By June 2008, the U.S. shadow banking system was approximately the same size as the U.S. traditional depository banking system. The equivalent of a bank run occurred within the shadow banking system during 2007-2008, when investors stopped providing funds to (or through) many entities in the system. Disruption in the shadow banking system is a key component of the ongoing subprime mortgage crisis.
By definition, shadow institutions do not accept deposits like a depository bank and therefore are not subject to the same regulations. Familiar examples of shadow institutions included Bear Stearns and Lehman Brothers. Other complex legal entities comprising the system include hedge funds, SIVs, conduits, money funds, monolines, investment banks, and other non-bank financial institutions.
Shadow banking institutions are typically intermediaries between investors and borrowers. For example, an institutional investor like a pension fund may be willing to lend money, while a corporation may be searching for funds to borrow. The shadow banking institution will channel funds from the investor(s) to the corporation, profiting either from fees or from the difference in interest rates between what it pays the investor(s) and what it receives from the borrower.
Many “shadow bank” like institutions and vehicles have emerged in American and European markets, between the years 2000 and 2008, and have come to play an important role in providing credit across the global financial system.
In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, described the growing importance of the shadow banking system: “In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.” In other words, lending through the shadow banking system slightly exceeded lending via the traditional banking system based on outstanding balances.
Shadow institutions are not subject to the same safety and soundness regulations as depository banks, meaning they do not have to keep as much money in the proverbial vault relative to what they borrow and lend. In other words, they can have a very high level of financial leverage, with a high ratio of debt relative to the liquid assets available to pay immediate claims. High leverage magnifies profits during boom periods and losses during downturns.
Shadow institutions like investment banks borrowed from investors in short-term, liquid markets (such as the money market and commercial paper markets), meaning that they would have to frequently repay and borrow again from these investors. On the other hand, they used the funds to lend to corporations or to invest in longer-term, less liquid (i.e., harder to sell) assets. In many cases, the long-term assets purchased were the mortgage-backed securities sometimes called “toxic assets” or “legacy assets” in the press. These assets declined significantly in value as housing prices declined and foreclosures increased during 2007-2009.
In the case of investment banks, this reliance on short-term financing required them to return frequently to investors in the capital markets to refinance their operations. When the housing market began to deteriorate and the ability to obtain funds from investors through investments such as mortgage-backed securities declined, these investment banks were unable to fund themselves. Investor refusal or inability to provide funds via the short-term markets was a primary cause of the failure of Bear Stearns and Lehman Brothers during 2008.
In technical terms, these institutions are subject to market risk, credit risk and especially liquidity risk, since their liabilities are short-term while their assets are more long-term and illiquid. This creates a potential problem in that they are not depositary institutions and do not have direct or indirect access to the support of their central bank in its role as lender of last resort. Therefore, during periods of market liquidity, they could go bankrupt if unable to refinance their short-term liabilities. They were also highly leveraged. This meant that disruptions in credit markets would make them subject to rapid deleveraging, meaning they would have to pay off their debts by selling their long-term assets.
The securitization markets frequently tapped by the shadow banking system started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds. In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.
U.S. Treasury Secretary Timothy Geithner stated that the “combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles.”