When the shadow eclipsed the moon

A brief history of shadow banking

By Jennifer Liu and Brian Lum

Shadow banking has been on Mark Carney’s mind for a while. Since his appointment as chair of the Financial Stability Board (FSB) in November 2011, the governor of Bank of Canada was given a number of tasks by the leaders of the Group of 20 large economies to spearhead global banking reforms. Shadow banking, according to Carney, is one of “the areas that absolutely amplified the last crisis and will do so again unless we complete our agenda….There must be a more robust approach to shadow banking.”

What is “shadow banking”? The FSB loosely defines shadow banking as non-bank credit intermediation. There is a debate on what qualifies as non-bank credit intermediation but this definition could include:

• Money market funds (MMFs)
• Hedge funds
• Special purpose or investment vehicles (SPVs or SIVs)
• Venture financial funds
• Repo/Securities lending

In the last decade, the size of the shadow banking system has grown significantly. In the FSB’s 2012 “Global Shadow Banking Monitoring Report,” it is estimated that the assets in the global shadow banking system increased from USD $26 trillion in 2002 to USD $62 trillion in 2007[1]. That means that, at their peak in 2007, shadow banking assets represented 27 percent of the global financial system and around half the size of banking system assets. At one point from 2004 to 2008, the size of shadow banking in the U.S. surpassed that of the traditional banking sector.       

Though its share of total financial intermediation has decreased since the crisis, shadow banking is still growing. In 2011, shadow banking assets reached USD $67 trillion.

Shadow banking has existed around the world and is barely a new phenomenon. The history of shadow banking dates as far back as the beginnings of non-bank credit intermediation entities. However, it was not until 2007 when Paul McCulley ostensibly first coined the term shadow banking. Shadow banking provides a valuable alternative to bank funding but it can also create bank-like risks to financial stability. But, unlike banks, non-bank entities in the shadow banking system are usually subject to less or no regulatory oversights. During the crisis, the vulnerabilities of the shadow banking system and its amplifying effects on systemic risk were powerfully revealed.

For example, during the financial crisis, shadow bank lending activities in the U.S. decreased significantly. In contrast, lending from the traditional banking system only marginally declined. The sharper lending contraction by shadow banks only exacerbated the problems faced by the financial system[2].

The crisis provided valuable lessons to regulators around the world. FSB in particular pinpointed the following key issues in the shadow banking system during the crisis:

• Dislocation of asset-backed commercial paper (ABCP) markets
• The failure of an originate-to-distribute model employing SIVs and conduits
• “Runs” on MMFs
• Sudden reappraisal of the terms on which securities lending and repos were conducted

Recognizing the important role of shadow banking in the financial system, regulators want to proactively address these issues and reform the sector so that it can serve as a valuable building block in a more stable financial system.

In a second blog “Bringing shadow to light,” we will look at recent regulatory proposals that aim to reshape the shadow banking industry and the implications on the financial industry.

How do you think the financial crisis has affected the shadow banking sector? Join the discussion.

[1] Shadow Banking Size – Financial Stability Board, Global Shadow Banking Monitoring Report 2012

[2] Shadow Banking Liabilities vs. Traditional Banking Liabilities – Federal Reserve Bank of New York Staff Reports