Shadow Banking

Jun 7, 2010

dictionary-150[Note: updated on 2.16.2011]

What is shadow banking?

Shadow banking refers to non-bank lenders that escape the regulatory oversight of many financial institutions. For example, because they don't accept deposits like commercial banks, they are exempt from leverage ratio requirements, which allows them to have high debt levels. They are highly exposed to liquidity risk, because they rely on short-term financing for long-term investments (such as mortgage-backed securities). They also do not have the backing of a central bank as a lender of last resort.

What’s the significance?

These institutions play a large role in providing credit to our financial system and are linked with the economic meltdown. Without strong regulations, many fear that they will lead to yet another catastrophic financial crash.

Who’s talking about it?

The term itself was coined by Paul McCulley of PIMCO when he referred to "the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures"...Paul Krugman of the New York Times and Ezra Klein of the Washington Post both trace the cause of the economic meltdown to a "run" on shadow banks when credit dried up...The Financial Crisis Inquiry Commission held hearings on shadow banking...Rob Johnson sent a letter to the Financial Stability Oversight Council urging aggressive implementation of reforms on shadow banking...Mike Konczal notes that GE operates a major shadow bank and therefore its executives may not be all about job creation...The shadow banking sector is thought by many to be a strong candidate for causing the next financial meltdown.

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