Shadow banking system

Based on Wikipedia: Shadow banking system

The Sixty-Three Trillion Dollar System You've Never Heard Of

There's a banking system operating right alongside the one you know—the one with the familiar logos on street corners, the one that holds your checking account and approves your mortgage. This parallel system now holds sixty-three trillion dollars in assets. That's not a typo. Sixty-three trillion, representing seventy-eight percent of the entire global economy.

And most people have never heard of it.

It's called shadow banking, though some in the industry wince at the term and prefer "market-based finance." The name carries a whiff of criminality that isn't entirely fair. These institutions aren't illegal. They're not hiding from regulators in dark alleys. They're hedge funds and insurance companies, money market funds and investment banks. They're the firms that manage pension funds and the entities that package mortgages into securities. They operate in broad daylight, in glass towers on Wall Street and in the City of London.

What makes them "shadow" isn't secrecy. It's that they perform the essential functions of banking—taking money from people who have it and lending it to people who need it—while operating outside the regulations that govern traditional banks.

What Banks Actually Do

To understand shadow banking, you first need to understand what regular banking actually is. At its core, a bank does something remarkably simple: it takes deposits from savers and makes loans to borrowers. The magic happens in the middle. Your savings account might pay you one percent interest, while the bank charges five percent on a car loan. That spread—the difference between what the bank pays you and what it charges borrowers—is how banks make money.

But there's a catch. Banks are playing a dangerous game with time. Your savings account lets you withdraw money whenever you want. The car loan, meanwhile, won't be paid back for five years. What happens if everyone wants their deposits back at once? The bank doesn't have the cash. It's lent out.

This mismatch between short-term deposits and long-term loans has caused banks to fail since banking began. It's why we had bank runs in the nineteenth century—panicked depositors lined up around the block, desperate to withdraw their money before the vault ran empty.

Governments eventually built safety nets to prevent these panics. In the United States, the Federal Deposit Insurance Corporation guarantees your deposits up to a quarter million dollars. If your bank fails, you still get your money. Banks also gained access to the Federal Reserve's lending window—a source of emergency cash when they need it. In exchange for these protections, banks accept extensive regulation. They must hold certain amounts of capital in reserve. They submit to regular examinations. They follow rules about who they can lend to and how much risk they can take.

Shadow banks do something similar to traditional banks—channeling money from savers to borrowers—but without those safety nets. And without those regulations.

Who Are These Shadow Bankers?

The term "shadow banking" covers an astonishing variety of institutions. At one end, you have the exotic: structured investment vehicles with names like alphabet soup, special purpose entities designed by lawyers to sit just outside regulatory boundaries, and collateralized debt obligations that became infamous during the 2008 financial crisis.

At the other end, you have institutions that seem almost mundane. Money market funds, for instance, are where many Americans park their spare cash. These funds invest in short-term, low-risk debt and pay slightly better interest than a regular savings account. Over four trillion dollars sits in American money market funds alone.

In between, you find hedge funds managing money for wealthy investors, insurance companies making complex bets on financial markets, private equity firms buying and restructuring companies, and the repurchase agreement market—usually called the "repo market"—where institutions borrow money overnight using securities as collateral.

The distinctions matter because these institutions carry very different risks. Money market funds, for instance, are heavily regulated and don't use leverage—they don't borrow money to amplify their bets. They're considered among the safest investments available. Hedge funds, by contrast, often borrow heavily to magnify their returns, which also magnifies their potential losses.

What unites all these institutions is that they operate outside traditional bank regulation. They don't take deposits in the conventional sense, so they don't fall under the rules designed for deposit-taking banks. They found a different way to do banking.

The Originate-to-Distribute Revolution

For most of the twentieth century, banking worked like this: a bank made a loan, and then the bank held that loan until it was paid off. The bank that gave you your mortgage in 1965 probably still owned that mortgage in 1990. This created a powerful incentive for careful lending. If you're going to live with a loan for thirty years, you want to make very sure the borrower can pay it back.

Then came a revolution in how credit worked. Banks discovered they could make loans, bundle them together, and sell them to investors. This was called securitization. Your mortgage, combined with thousands of others, became a mortgage-backed security that could be traded like a stock or bond.

The model shifted from "originate and hold" to "originate and distribute." Banks made the loans, then distributed them to the broader financial system. This freed up capital to make more loans. It also spread risk across many investors rather than concentrating it in individual banks.

Hervé Hannoun, a senior official at the Bank for International Settlements—the central bank for central banks—described how this created an elaborate supply chain of credit. Banks would make loans, package them into securities with acronyms like ABS (asset-backed securities) and CDO (collateralized debt obligations), then slice these packages into pieces called tranches. The safest tranches went to conservative investors like pension funds. The riskier tranches, which paid higher returns, went to investors willing to gamble.

This system needed institutions to perform all these steps: originating loans, packaging them, rating them, selling them, and managing them. Shadow banks filled these roles.

The Rise

Shadow banking existed for decades, but it exploded after 2000. The growth was staggering.

In 2002, the global shadow banking sector held roughly twenty-seven trillion dollars. By 2007, just before the financial crisis, it had nearly doubled to fifty trillion. The United States led the way, but shadow banking grew everywhere—in Europe, in China, in financial centers around the world.

Several forces drove this expansion. Interest rates were low, pushing investors to search for higher returns wherever they could find them. Regulations on traditional banks created incentives to move activities into less-regulated entities. Financial innovation made it possible to create ever-more-complex instruments and structures. And globalization connected capital markets worldwide, allowing shadow banking to span continents.

By early 2007, the shadow banking sector in the United States alone had grown enormous. Timothy Geithner, then president of the Federal Reserve Bank of New York, laid out the numbers in a speech. Structured investment vehicles and asset-backed commercial paper programs held 2.2 trillion dollars. The overnight repo market—where institutions borrow against securities for just one day—had grown to 2.5 trillion. Hedge funds managed 1.8 trillion. The five major investment banks held four trillion on their balance sheets.

To put this in perspective: the entire traditional banking system in the United States held about ten trillion in assets. Shadow banking had grown to rival it in size.

The Fall

Then came 2008.

The financial crisis exposed the vulnerabilities that had been building in the shadow banking system for years. At its heart was a simple problem: shadow banks had borrowed short and lent long, just like traditional banks always have. But they lacked the safety nets that traditional banks enjoy.

Many shadow banking entities had funded themselves in short-term markets—borrowing money overnight or for just a few weeks—and used those funds to buy long-term assets like mortgage-backed securities. This worked beautifully as long as lenders kept rolling over those short-term loans. But when fear gripped the markets, lenders stopped lending.

The repo market, that 2.5-trillion-dollar engine of overnight borrowing, seized up. Lenders who had happily accepted mortgage-backed securities as collateral suddenly didn't want them anymore. Institutions that had relied on rolling over their short-term borrowing every day found themselves unable to borrow at all.

It was a bank run, but not the kind your grandparents might remember. No one lined up outside a building. Instead, institutions simply stopped lending to each other. The plumbing of the financial system froze.

Investment banks, those giants that straddled the line between shadow and traditional banking, toppled one after another. Bear Stearns was acquired by JPMorgan Chase in a government-brokered rescue. Lehman Brothers declared bankruptcy—the largest bankruptcy in American history. Merrill Lynch sold itself to Bank of America. Morgan Stanley and Goldman Sachs, the last two major independent investment banks, converted themselves into bank holding companies, bringing themselves under traditional banking regulation in exchange for access to Federal Reserve emergency lending.

The shadow banking sector shrank. Global assets fell from fifty trillion in 2007 to forty-seven trillion in 2008. In the United States, the decline was even sharper and more lasting.

The Rise Again

But here's the remarkable thing: the shadow banking system recovered. And then it grew far larger than before.

By late 2011, global shadow banking assets had climbed back to fifty-one trillion dollars—slightly above their pre-crisis peak. By 2012, some academic estimates suggested the true size might have exceeded one hundred trillion, though measuring shadow banking precisely is notoriously difficult.

By 2016, the Financial Stability Board—the international body that monitors global finance—estimated the sector at one hundred trillion dollars. By 2022, their figure had reached sixty-three trillion, though this used a narrower definition than some earlier estimates.

What explains this phoenix-like return? Partly, low interest rates. In the years after the crisis, central banks pushed interest rates to historic lows, even negative in some countries. Investors desperately seeking returns looked beyond traditional banks to find them. Shadow banking institutions offered those returns.

Partly, it was regulatory arbitrage. After the crisis, governments tightened rules on traditional banks. Banks had to hold more capital, take less risk, and submit to more oversight. Some activities that had been profitable for banks became unprofitable under the new rules. Those activities migrated to shadow banking, where the old regulations didn't apply.

A paper published in 2024 noted that American financial institutions had loaned more than one trillion dollars to shadow banks. The shadow banking sector had become so large and so interconnected that traditional banks couldn't avoid it even if they wanted to.

China's Shadow Banking Boom

While shadow banking originated in the United States and Europe, China developed its own version—and it grew explosively.

Chinese shadow banking looks different from its Western counterpart. Instead of complex securities and hedge funds, it often involves arrangements with names like trust loans, entrusted loans, and wealth management products. These sound bureaucratic because they emerged from a highly regulated financial system looking for ways around those regulations.

Chinese banks face strict limits on how much they can lend and what interest rates they can charge. Shadow banking offered a workaround. A bank might arrange for one of its corporate customers to lend money to another customer, with the bank earning a fee for arranging the transaction. Or a bank might sell "wealth management products" to depositors—essentially promising higher returns by investing the money outside the bank's balance sheet.

Between 2002 and 2018, shadow banking activities in China grew rapidly. These activities were closely connected to the formal banking system—often they were essentially bank loans dressed up in different legal clothing to avoid regulations.

Chinese regulators have struggled to bring these activities under control. The oversight is weaker than for traditional bank lending, and the web of connections between shadow banking and the formal banking sector creates risks that are difficult to measure.

Why Shadow Banking Matters

You might wonder why any of this matters to you if you don't work on Wall Street. The answer lies in what happened in 2008—and what could happen again.

Shadow banking provides credit to the economy. Before the financial crisis, the shadow banking system in America had actually overtaken traditional banks in supplying loans. Businesses borrowed from shadow banks. Home buyers got mortgages originated by shadow banking entities. Car buyers, students, credit card users—all of them benefited from credit flowing through the shadow system.

This isn't necessarily bad. Shadow banks can sometimes provide credit more cheaply than traditional banks. Their specialized structures allow them to match borrowers and investors efficiently. A pension fund with money to invest and a corporation that needs to borrow can find each other through shadow banking intermediaries.

Shadow banks also sometimes lend to borrowers that traditional banks won't touch. They can be less conservative, more willing to take risks. For borrowers who've been turned down by banks, this can be their only option.

But the risks are real. Shadow banks use leverage—they borrow money to amplify their bets. When things go well, this magnifies profits. When things go badly, it magnifies losses. And because shadow banks don't have access to central bank emergency lending or deposit insurance, a panicked rush for the exits can bring the whole system down.

The International Monetary Fund identified two key functions that shadow banking performs. First, securitization—creating supposedly safe assets by packaging loans together. Second, collateral intermediation—helping institutions put up collateral for their transactions. Both of these functions are valuable. Both created catastrophic problems in 2008 when the supposedly safe assets turned out to be toxic and the collateral turned out to be worth far less than people thought.

The Leverage Problem

Leverage is a seductive and dangerous thing.

Imagine you have one hundred dollars and you want to invest in real estate. Without leverage, you buy one hundred dollars worth of property. If the property goes up ten percent, you've made ten dollars. If it goes down ten percent, you've lost ten dollars.

Now imagine you borrow nine hundred dollars and combine it with your hundred. You buy a thousand dollars worth of property. If it goes up ten percent, you've made a hundred dollars—a hundred percent return on your initial investment. Leverage has multiplied your gains tenfold.

But what if the property falls ten percent? You've lost a hundred dollars. Your entire investment is wiped out. And you still owe the nine hundred you borrowed.

Shadow banking institutions often operate with high leverage. They borrow heavily to amplify their returns. During good times, this makes them look like geniuses. They're generating returns that traditional banks, constrained by regulations limiting their leverage, can't match.

But this performance comes from taking greater risks, not from superior skill. And investors might not realize this until the downturn comes.

Traditional banks must maintain certain capital ratios—they can only borrow so much relative to their assets. Shadow banks face fewer such constraints. This means they can take on more leverage, which means they can generate higher returns during booms and suffer worse losses during busts.

The Maturity Mismatch Problem

There's another vulnerability built into the structure of many shadow banking activities: the mismatch between short-term borrowing and long-term lending.

Consider a structured investment vehicle—one of those alphabet-soup entities that proliferated before the crisis. It might borrow money by issuing commercial paper, which is short-term debt that comes due in days or weeks. It uses that borrowed money to buy mortgage-backed securities, which won't be paid off for years or even decades.

Every few days or weeks, the vehicle has to roll over its commercial paper—find new lenders willing to provide short-term funding. As long as lenders are willing, this works fine. But if lenders get nervous—if they start to wonder whether those mortgage-backed securities are really worth what the vehicle says they're worth—they might refuse to roll over their loans.

Suddenly the vehicle is in crisis. It owes money that's coming due, but it can't borrow more. Its only option is to sell assets. But if everyone is trying to sell the same assets at the same time, prices collapse. The vehicle can't raise enough cash. It fails.

This is exactly what happened in 2008. Short-term lending markets froze. Institutions that relied on rolling over overnight borrowing couldn't get funding. Asset prices collapsed as desperate sellers flooded the market.

The Regulatory Response

After the crisis, regulators faced a dilemma. Shadow banking had clearly contributed to the catastrophe. But simply banning it wasn't realistic—the activities served real economic purposes, and they'd just move to jurisdictions with lighter regulation.

The response has been gradual and incomplete. The Group of Twenty—the forum where leaders of the world's largest economies coordinate policy—asked the Financial Stability Board to develop recommendations for regulating shadow banking. The Board finalized its recommendations in 2013, with implementation beginning in 2015.

The approach focused on reducing the risks that shadow banking poses to the broader financial system. Rather than regulating shadow banks exactly like traditional banks, the rules aimed to limit the connections between the two sectors—to build firewalls that would prevent problems in shadow banking from spreading to traditional banks and vice versa.

Money market funds, despite being relatively simple and transparent, received particular attention. In 2010, the Securities and Exchange Commission in the United States adopted reforms requiring money market funds to maintain higher liquidity and better disclose their holdings. But some argued these reforms didn't go far enough, while others questioned whether money market funds—which don't use leverage and are already heavily regulated—should be lumped in with riskier shadow banking activities at all.

European and American regulators also looked at securitization—the process of bundling loans into tradeable securities. New rules required originators to keep some skin in the game, holding onto a portion of the securities they created rather than selling everything to investors. The theory was that this would align incentives—if you have to eat your own cooking, you'll be more careful about what goes into the recipe.

The Ongoing Tension

But here's the irony: stricter regulations on traditional banks may be pushing more activity into shadow banking.

When you make it more expensive for banks to do something, they stop doing it. The activity doesn't disappear—it migrates to entities that face lower costs. Shadow banks, with their lighter regulatory burden, can often offer better terms. Business flows to them.

Benoît Cœuré, a member of the European Central Bank's executive board, warned in 2016 that controlling shadow banking needed to be a priority. Banks had reduced their leverage after the crisis, making them safer. But shadow banking had grown to fill the gap. The risks hadn't disappeared—they'd just moved.

This cat-and-mouse game between regulators and financial institutions is perhaps inevitable. Finance is endlessly creative at finding ways around rules. New structures emerge. Old definitions become obsolete. By the time regulators understand and address one risk, the system has evolved.

Looking Forward

As of late 2022, shadow banking holds sixty-three trillion dollars—larger in relative terms than before the financial crisis. The sector has evolved since 2008. Some of the most dangerous structures have disappeared or changed. Money market funds are more tightly regulated. Investment banks have converted to bank holding companies. Securitization continues but under stricter rules.

Yet the fundamental dynamics remain. Institutions outside traditional banking regulation still perform banking-like functions. They still rely on short-term funding for long-term activities. They still use leverage to amplify returns. They remain connected to traditional banks through a web of lending and borrowing relationships.

The next crisis, when it comes, might not look like 2008. Financial crises rarely repeat exactly. But the shadow banking system—that sixty-three-trillion-dollar engine of credit and risk—will almost certainly be involved somehow.

Perhaps the strangest thing about shadow banking is how it persists despite everyone knowing its risks. The 2008 crisis wasn't exactly a secret. Millions of people lost jobs, homes, and savings. Governments spent trillions stabilizing the financial system. Yet the shadow banking sector is bigger than ever.

This persistence suggests something fundamental about modern finance. There's an appetite for credit that traditional banking, with all its regulations and capital requirements, cannot fully satisfy. There's a demand for returns that safe investments cannot provide. Shadow banking fills these gaps.

Whether it can do so without periodically blowing up the global economy remains an open question. The answer, unfortunately, may require another crisis to reveal.