The unregulated shadow banking system triggered the 2008 financial crisis

by. Robert Lenzner

The 2008 financial crisis was triggered by a run on short term bank debt, illiquidity in the commercial paper market and a sudden lack of confidence in the money market mutual fund industry. All three of these financial products are part and parcel of what is called the “shadow banking system,” which cannot  depend on the safety net of  either a lender of last resort like the Fed or regulatory agencies that can intervene to deal with the volatility of a run.

As Yale economist Gary Gorton put it in his book, Misunderstanding Financial Crises: Why We Don’t See Them Coming, only a late bold move by the Fed and Treasury to guarantee the commercial paper market, to guarantee bank deposits up to $250,00, and inject the banks with tens of billions, saved the day. We learned that banks cannot survive without the substantial injection of short term funds from a sudden panicky withdrawal in the repo market, the money market mutual funds or commercial paper.  A chart in the Financial Crisis Inquiry Commission Report underscored the significance of “shadow banking” by showing it as a larger dollar amount than traditional banking from 2004 until 2008. “The new shadow banks,” blares the report, issued in early 2011,”had few constraints on raising and investing money.” There was no regulation then and the situation has not been rectified. It is the reason Gorton predicts we will be blindsided again by the next financial crisis.

Curious, isn’t it, that until very recently the financial media has had very little focus on the “shadow banking system,” as distinct from the regular banking system represented by giant institutions like  J.P. Morgan Chase, Citigroup and Bank of America. In point of fact, former Treasury Secretary and current Harvard economist Larry Summers underscored for me his anxiety over the continuing lack of regulation in the “shadow banking system,” suggesting that it could again by the locus of instability. In other words, it’s definitely time for “shadow banking” to come out of the shadows.

Lately, we have had a cover story from the Economist called “Shadow and Substance,” which raises the question of whether the world of finance is safer now that “shadow banks are taking on a growing share of their business” away from traditional banks. The Financial Times has published a series of pieces on the “shadow banking” phenomenon including a column by Paul Tucker,  former deputy governor of the Bank of England, who wrote recently that “tightening banking regulation is not sufficient to prevent excessive liquidity risk and leverage among so-called ‘shadow banks’ brewing another crisis down the road. That is a strong lesson from the US experience during the 2007-09 crisis, when myriad varieties of shadow banking collapsed in a heap, spreading panic and distress through the world economy.”

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