The term ‘shadow banking’ sounds a bit suspicious and maybe even sinister, especially after what happened in 2008 when the shadow banking system ran amok with a domino effect on global  financial markets.

Shadow Banking Definition

Paul McCulley,  expert economist, coined the term ‘shadow banking’ in 2007.  The term has taken on many different definitions since then.  Paul’s definition of shadow banking is the following:  Entities engaged in old-fashioned banking activity (maturity, liquidity and credit transformation), but without a backstop against a run.

A run on a bank is when a large number of depositors withdraw their money in a panic because they are afraid the bank will become insolvent.  Did you see “It’s a Wonderful Life”?  Boom.  Our standard banking system has regulations or backstops in place such as deposit insurance (FDIC) and the lender of last resorts (Federal Reserve in the US)) to deal with the challenge of bank runs.

Shadow Banking Regulation

The shadow banking system is gaining momentum again with optimism that new regulations will prevent another disaster similar to 2008.

The Financial Stability Board (FSB), an organisation of international policy makers for global financial stability is leading the way to establish and monitor regulations for the shadow banking system.

The FSB has reported that there has been important progress on establishing regulations, but agreed principles have not been implemented nationally.  The  regulations seek to find the perfect balance between preserving the benefits of shadow banks and containing the vulnerabilities inherent with the risks.

The FSB process for addressing challenges is to use a 3-stage process of vulnerability assessment, policy development and coordination, and implementation monitoring.

Paul McCulley explained the challenge of regulation as being to find the balance between the invisible hand of free market creativity doing it’s magic, and the visible fist of the government to protect against vulnerabilities.

Shadow Banking Education

There are some excellent books and videos to help explain shadow banking and the international impact of this system.

This video from “The Economist” explains in layman terms the pros and cons of shadow banking, regulations, impact on money market funds and how institutions have evolved since the 2008 crisis.

Paul McCulley explains the term he coined, ‘shadow banking,’ and shares his optimism regarding the future challenges and solutions.

The Dogz took an online class called ‘Economics of Money & Banking’ taught by Perry G. Mehrling, Professor of Economics at Barnard College.  He explained shadow banking in detail.  That class was offered last fall on Coursera.  If you want to understand the fundamentals of shadow banking from a pro, get your coffee, strap yourself in and watch the below video.