2 Ways to Protect Yourself While Shadow Banking

When it comes to money, it's important to weigh the risks.

We should all remember the words of English philosopher and statesman Francis Bacon who famously said, "Knowledge is power." To safely deal with shadow banking, it is crucial that you have knowledge of what it is and how to protect yourself from any less-than-desirable outcomes.

What is shadow banking?

It's easy to believe that the company loaning money for a mortgage is a traditional mortgage lender or that the place you're borrowing money from to remodel your basement is a bank or credit union.

As the International Monetary Fund (IMF) puts it: "If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck -- or so the saying goes. But what about an institution that looks like a bank and acts like a bank?"

Spoiler alert: It may not be a bank at all.

A "shadow bank" is a financial institution that performs like a bank but is, in fact, a company with no government oversight regarding banking practices.

One of the most recognizable shadow banks is Quicken Loans, the largest mortgage lender in the U.S. As a company, Quicken Loans has done a lot of things right. It's known for outstanding customer service, provides quick and convenient home closings, and contributes to overall economic activity.

However, it's still a shadow bank.

The difference

To understand how shadow banking can be a risk to your bank account, it helps to understand the difference between traditional banking and shadow banking.

Traditional banking

• Makes mortgage, auto, home equity, and personal loans using deposits from its customers.
• Required to comply with strict standards and restrictions set by the Federal Reserve.
• Heavily regulated by federal and state authorities.
• Provides protection against loss of deposit through FDIC or NCUA.

Shadow banking

• Makes mortgage, auto, home equity, and personal loans using investor dollars.
• Not considered a banking institution and not required to comply with Federal Reserve restrictions.
• No banking oversight provided by federal or state authorities.
• No commitment to a particular community, meaning there's no concern regarding consumer blowback if things go south.
• Funds channeled through a shadow bank are not insured by any organization.

Major risks and how to protect yourself

As Quicken Loans illustrates, not all shadow banking is shoddy. Your risk as a consumer is believing that you have the same protections through a shadow bank as you would receive through a traditional bank or credit union.

Here are two of the major issues stemming from shadow banks:

1. No safety net

Let's say you want to open a money market account (MMA) to use as an emergency savings account. Your local bank is paying an APY of 2.5%, but another financial institution is paying 4.5%.

Naturally, you want a higher interest rate and deposit the funds through the other financial institution. It's not as though you've never heard of the other financial institution, and you figure it must have tons of money on hand. You're not even worried that the funds are not FDIC insured as they would be through the local bank.

Another pandemic (or some other financial crisis) hits. If you'd deposited your money at your local bank, it would have been able to borrow money from the Federal Reserve to ensure that you had access to your account when needed.

Unfortunately, shadow banks have no access to short-term, government-backed funding. To come up with extra cash, they're forced to sell assets. If they're unable to sell enough assets to cover deposits, you could lose some or all of the money in your MMA.

Takeaway No. 1: Don't just look at APR when deciding where to deposit your money. Unless you're comfortable with the risk a shadow bank represents, look for a financial institution that is FDIC or NCUA insured.

2. Potential lack of liquidity

All financial institutions need access to capital to operate. One of the reasons the 2008 financial crisis grew out of control so quickly is that there was no short-term funding available to many institutions that depended on it to keep their doors open.

Traditional banks and credit unions are required to maintain a specific level of liquidity. In fact, if they fall below that amount, they must take immediate steps to correct the issue. The same is not true for shadow banks.

In the years leading up to the 2008 collapse, shadow banks risked liquidity. When all the wheeling and dealing was done, and people began defaulting on their mortgages, those lending institutions did not have the funds required to stay afloat.

There's plenty of blame to go around for the 2008 collapse, but part of it belongs to shadow banking.

Takeaway No. 2: Whether you're taking out a loan or making a deposit, be aware that shadow banks represent a higher risk.

Few things are all bad or all good, and that includes shadow banks. According to the Washington Post, shadow banks controlled nearly half of all global financial assets at the end of 2020, or $225 trillion. On the other hand, traditional banks controlled $180 trillion in assets at the end of 2020.

Clearly, shadow banking is not going anywhere. And while properly-managed shadow banking can help drive the economy, it's vital to understand the associated risks.