Shining a light on shadow banking: Benefits, risks, and regulations

Although the word “shadow” might make it seem sketchy, shadow banking is a legitimate, important component of the global financial system. Also known as non-bank financial intermediation (NBFI), the shadow banking system consists of non-bank financial intermediaries that provide credit and financial services similar to those offered by traditional banks, but that operate with less regulation and oversight. As of 2022, the Financial Stability Board reported that the global shadow banking system held over $239 trillion in assets, or 49.17% of total financial sector assets.

Shadow banking examples include money market funds, hedge funds, and investment banks. For example, a company could take out a loan from a bank, or it could borrow money from a hedge fund that specializes in private credit. It could have an overdraft line with its bank, or it could issue commercial paper through an investment bank. Businesses are constantly looking for ways to manage their funds more effectively (i.e., inexpensively), and sometimes, their best alternative is outside the commercial banking system.

What shadow banks do

Shadow banks, then, offer financial services outside the commercial banking system. They typically involve sophisticated investors who understand and can bear complex risks. For example, a hedge fund can raise money from wealthy individuals or institutions and use the funds to purchase portfolios of mortgages or credit card receivables. These mortgages and credit card loans were probably issued by a commercial bank that receives funding through federally insured deposit accounts. This helps the bank take long-term assets off its balance sheet (the better to match its short-term deposits) and make loans to more customers.

This example shows some of the many of the functions of shadow banking, which include:

• Securitization. Shadow banks buy packages of loans from banks and convert them into securities that can be sold to investors.
• Alternative credit. Shadow banks often write loans to fund businesses or real estate projects, especially risky or complicated loans that commercial banks cannot or will not take on.
• High-interest savings. Money market funds are shadow banking institutions that use money from investors to purchase commercial paper—short-term securities used to fund business operations. These give savers interest rates that tend to be higher than those offered by commercial banks, although without the benefit of deposit insurance.
• Innovative financial products. Collateralized debt obligations (CDOs) and credit default swaps (CDS) are among the products that shadow banks work with. Their willingness to take risks and try new products helps the financial system innovate.

Concerns about shadow banks

Non-bank financial intermediaries have been around for a long time. Although they’ve earned the “shadow banks” nickname, they play a key role in the financial system. Still, there are concerns about them that haven’t gone away:

• Lack of transparency. Shadow banks may not commit fraud or violate securities laws, but they don’t have the same level of day-to-day oversight as commercial banks. This means there isn’t good data on the amount of non-bank banking activity in the economy and the risks that may result from it.
• Credit and liquidity risks. Some non-bank banks rely on short-term funding sources; if lenders suddenly withdraw their funds, it can lead to a rapid sell-off of assets. Other shadow banks are involved with complex financial products that have high credit risks, and those risks might not be fully understood.
• Systemic risk. Given the interconnectedness of financial markets, disruptions in the shadow banking system can have ripple effects throughout the broader financial system, potentially leading to systemic crises.

The risks in the shadow banking system play out in different ways. For example, when short-term interest rates are high relative to long-term rates (a so-called “inverted yield curve”), many savers pull their money out of insured bank accounts and move funds into money market mutual funds, which invest in commercial paper. This pulls money out of the banking system and may interfere with the Federal Reserve’s attempts to manage the economy. And, if there is stress in the commercial paper market, then money market funds are at risk—which happened in 2008.

Regulating shadow banks

The term “shadow bank” was coined in 2007 in a speech given by economist Paul McCulley, although the components and functions of the system had been at work for decades before that. McCulley was speaking before the financial crisis of 2008, and he was concerned that the financial system was exposed to risk from non-bank financial institutions that had a maturity mismatch between their assets and liabilities. For example, many of these firms were borrowing short-term funds in the money market to make long-term loans. In a crisis, they might not be able to raise the funds to pay off the short-term borrowing—which is exactly what happened to many companies in 2008.

In the aftermath of the 2008 financial crisis, many regulatory reforms were introduced to make the traditional banking sector safer. One was creating a formal organization to monitor shadow banking activities; the result was the Financial Stability Board.

The bottom line

Despite its ominous-sounding name, shadow banking is integral to the financial system. It represents a parallel financial system that operates alongside traditional banking, but with fewer regulations and more complexity.

As financial markets continue to evolve, it remains a challenge for regulators to strike the right balance between promoting innovation and safeguarding financial stability in the shadow banking sector. Addressing these challenges effectively is essential for reducing the potential threats that shadow banking can pose to the broader financial system.

Commercial banks play an important role in the financial system in part because regulation and deposit insurance create stability. However, regulatory requirements force banks to be conservative. Non-bank financial institutions exist to serve investors who can bear greater risk and borrowers who have more complex needs than commercial banks can handle.