So What Is Shadow Banking?
A "shadow bank" is any unregulated financial institution that acts like a bank but instead of financing activities through deposits, it does so through investors, borrowing, or creating financial products. The world of shadow banking includes hedge funds, private equity firms, special purpose vehicles, insurance companies, crowdfunding organizations, and money market funds.
But it also includes traditional financial institutions. Leading up to the financial crisis, commercial banks were very active in the sector, as were government-sponsored entities like Freddie Mac and Fannie Mae. These businesses still have activities that are "off the books," meaning that, despite new regulations, they're still participating in shadow activities. As of May 2013, one estimate put traditional banks' share of the shadow sector at 22%.
Wait, I Thought Shadow Banks Were Supposed to be... Shadowy
To understand the reasons behind commercial bank involvement in shadow banking, it helps to have some information about the history of bank regulation (I'm not addressing Fannie and Freddie here -- that's a whole other animal).
Essentially, after the Great Depression and the Glass-Steagal Act, commercial banks were tightly regulated in order to preserve the stability of the financial system. For example, the Fed could cap the interest rates that banks paid to depositors. When interest rates were low, that was fine, but when inflation started rising new competitors came on the horizon.
In the 1970s, a group of unregulated entities like Merrill Lynch and Morgan Stanley invented the money market fund to woo customers from commercial banks. Taking investor dollars and offering short-term corporate loans to big companies, these companies were able to provide a higher interest rate than the typical checking account. A similar market arose among securities dealers looking for short-term liquidity by buying and selling Treasuries to each other (now called the "repo" market, after the repurchase agreements that characterize it).
The Rise of Deregulation
Of course, commercial banks weren't thrilled about their loss of competitiveness, and thus began a long campaign for deregulation. Over the following decades, restrictions were reduced one after the other so that banks could compete with their unregulated counterparts.
To paraphrase the government's sprawling and utterly fascinating report on the crisis, commercial banks started to look more and more like investment banks -- large, complex, and very active in the shadow sector. Finally, in 1999, the last limitations of Glass-Steagal were removed and commercial banks dived even further in, using borrowed (and thus unregulated) assets to finance activities.
In other words, by the time the crisis hit, commercial banks looked an awful lot like their unregulated counterparts -- with the risk profile to match.
Shadow Banking Activities
What else did shadow banks do that commercial banks wanted in on?
Broadly speaking, there are four types of activities. The more boring ones involve borrowing short-term or liquid assets to invest in long-term or illiquid ones. Also common is the use of leverage to magnify the returns on investments. Finally, and probably most poignantly from the perspective of the financial crisis, shadow banking involves the repackaging and transfer of risk. This includes securitizing loans, creating credit default swaps, and trading all of these on the derivatives market.
The latter activities are all highly profitable, and, in the end, very risky.
What are the Risks?
In the case of the financial crisis, we had a web of financial entanglements that no one really understood the depth or the value of, and we had commercial banks acting like investment banks. When the Fed enacted a seemingly random bailout policy, saving some institutions and allowing others to fail, the whole system locked up and suddenly the distinctions between regulated and unregulated activities, between safe and not safe, got very, very cloudy.
Today there are more stringent regulatory standards for large banks (investment banks too) and restrictions on certain types of activities that were formerly unmonitored. Thus, an increasing amount of lending, borrowing, and securitization has been pushed away from these banks toward the truly unregulated financial institutions.
Are Unregulated Shadow Banks a Risk?
The concern among regulators, however, is that a great degree of interconnectedness between those companies and the large banks is still in place. In other words, if a shadow bank goes down, regulators are concerned that it can still take "safe" banks with it.
These fears reflect a greater unease about our lack of visibility into the financial system as a whole: The amount of leverage built up among institutions, the degree of information disclosure and trust, the depth of a given web of exposures, and the ability of shadow banking activities to fuel inefficient bubbles.
For example, a company in bankruptcy that could successfully restructure might not be touched by a traditional bank with a 10-foot pole, but would be of immense interest to distressed debt funds investing in these transactions. Such specialization can provide liquidity to viable businesses and reduce the cost of financing.
So is There Any Upside to Shadow Banking?
Not all shadow banking is scary. Shadow banks provide liquidity where commercial and investment banks cannot, which if everyone understands the risks involved is probably a good thing.
On this front, shadow banking essentially operates alongside to commercial banks, financing investments and adding liquidity where it might not otherwise be forthcoming.
Of course, activities like securitization and credit-risk transfers don't do this -- they attempt to reduce risk or transfer it, but as we saw in the financial crisis that didn't exactly go very well. While the risks of these exposures are pretty well-documented by now, it's still an open question of how the authorities will deal with them.
For now, regulators are being more and more vocal in expressing concern about a lack of visibility into the sector and a need for some kind of baseline oversight. The trend certainly appears to be going in that direction, which will, more than likely, eventually bring shadow banking out of the shadows and into the light of day.