The term “shadow bank” was coined by economist Paul McCulley in a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming. The shadow banking system is a term for the collection of non-bank financial intermediaries (NBFIs) that provide services similar to traditional commercial banks but outside normal banking regulations.[1] Examples of NBFIs include hedge funds, insurance firms, pawn shops, cashier’s check issuers, check cashing locations, payday lending, currency exchanges, and microloan organizations.[2][3.
Former US Federal Reserve Chair Ben Bernanke provided the following definition in November 2013:
“Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions—but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper [ABCP] conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies”[5]
Shadow banking has grown in importance to rival traditional depository banking, and was a factor in the subprime mortgage crisis of 2007–2008 and the global recession that followed.
I remember first reading about the Shadow Banking system in 2007 and thinking, “Uh-oh, these guys are adding risk without any oversight by regulators.” That was during the 2007 housing bubble when NINJA mortgages were being packaged into derivatives with AAA ratings. The rest is history.
Risks from the shadow banking system are growing.
Banking Problems May Be Tip of Debt Iceberg
‘Shadow banks’ have grown rapidly and, like banks, are exposed to risk from higher interest rates
By Greg Ip, The Wall Street Journal, April 26, 2023
…[big snip about recent banking crisis]…
A lot of banks own similarly devalued bonds [as Silicon Valley Bank]. But that is just the tip of a debt iceberg. Since the end of 2009, total debt owed by governments, business and households has risen 90% to $68 trillion, according to the Federal Reserve.
Since early last year, interest rates have risen at their fastest pace since the early 1980s. When interest rates go up, the value of an existing loan or a bond goes down. This isn’t always apparent. Lenders don’t typically mark to market loans, and sometimes bonds, in their earnings statements.
But regardless of accounting treatment, the economic reality is that those bonds and loans are worth a lot less than when they were issued, and someone has to bear those losses…
Banks are the most visible debtholders, but, collectively, just as much debt is held by pension and mutual funds, private-credit funds, life insurers, business-development companies, hedge funds, and other nonbanks — or, as they are sometimes called, shadow banks…
Shadow banks have grown considerably since the global financial crisis. The fastest-growing segment is private credit — loans to companies generally too small to issue bonds but who want to avoid more restrictive bank loans. Since the start of 2008, private credit has grown almost sixfold, to $1.5 trillion, according to the IMF — bigger than the high-yield bond or leveraged-loan markets. At $4.4 trillion, those three markets are worth more than all banks’ commercial and industrial loans, at $2.7 trillion…[end quote]
The shadow banking system is opaque since reporting isn’t required. While some private credit is subject to interest-rate risk, the loans are often floating-rate and thus adjust upward with interest rates. Adjustable rates protect the lenders but put pressure on the borrowers who may be driven into default.
The huge size, opacity and unregulated high risk lending of the shadow banking system could trigger another financial crisis as it did in 2008. (Remember AIG?)
The higher interest rates rise and the longer they are held at a higher level (though not abnormally high by historical standards) the greater the risk of a crisis.
Wendy
