The minsky moment triggering the demise of US financial markets in 2008 stems from the fall of Lehman Brothers, underscoring unregulated risks associated with shadow banking. From 2008 to 2021, shadow banking increased at an unprecedented rate as investors and lenders bypass the scrutiny of traditional banking. The downsides, however, are the lack of safety nets in calculating actual risks. Following the financial crisis, traditional modes of central banking faced more stringent regulations. The myriads of rules imposed on banks consequently promoted the attractiveness of shadow banks.
In 2007, economist Paul McCulley coined the term “shadow bank” to refer to financial institutions engaging in maturity transformation. Maturity transformations occur when an institution deploys short-term capital deposits to finance long-term loans for clients. The chain of transactions can quickly multiply, rendering it near impossible to monitor any grave risks located in the lengthy process. Should an emergency result, shadow banks lack Federal Reserve funds to insure themselves against bankruptcy.
Experts Gary Gorton and Andrew Metrick indicate that shadow banks perform the equivalent functions as do traditional banks, only without the regulatory framework. They provide services in investment banking, money-market mutual funds (MMMFs), asset-backed securities (ABSs), collateralized debt obligations (CDOs), among others. In the aftermath of the financial crisis, Congress imposed tighter regulations such as requiring hedge funds to register with the Securities and Exchange Commission (SEC). Despite reforms, securitization might always be an enticing practice. As aforementioned, maturity transformation is an essential feature of shadow banking. At the heart of this process is securitization: packaging wealth management products as loans. For one, wealth management products offer clients a higher return on their asset deposits. Another compelling incentive is the availability of these packages opposed to the high bar of securing traditional loans without adequate cash flow.
Will there be another financial crash as crippling as the 2008 market crash? COVID-19 notwithstanding, the current practices of shadow banking loom as a real risk to the stability of the banking industry.
References
Ban, Cornel and Daniela Gabor, “The Political Economy of Shadow Banking,” Review of International Political Economy 23, no. 6 (2016).
Gorton, Gary and Andrew Metrick, “Regulating the Shadow Banking System,” Brookings Papers on Economic Activity, (Fall 2010).
Laura E. Kodres, “What is Shadow Banking,” International Monetary Fund, last modified June 2013, https://www.imf.org/external/pubs/ft/fandd/2013/06/basics.htm.