What is the shadow banking system?
Many note that the banking crisis of 2008 was primarily a crisis of the shadow banking system, although few know what that is. But if we want to plan for the next crisis, we need to understand the last one.
The shadow banking system is a product of banking regulation. In the ‘70s, banks were subject to Reg Q, which limited the interest they could pay. Naturally, 4% interest wasn’t very attractive to investors with inflation at 10% or higher. So some folks figured that by pooling their funds and investing in short-term instruments, they could earn a lot more than banks could pay.
Thus was born the first shadow banking institution, the money market fund. It pays interest to depositors and lends to corporations and the government. Today, the shadow banking system is a lot of funds that serve banking functions outside of banking rules. They may have rules, but not banking rules. AIG made markets in credit instruments, and when some of those bets went wrong their excessive leverage brought down the company. The big brokers made sub-prime loans, and when those loans went bad their excessive leverage brought them down.
It really was leverage that brought down the banking system, both shadow and traditional. Financial reform needs to address this. And not push people into a shadow-shadow world.
Douglas R. Tengdin, CFA
Chief Investment Officer
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