Unlike traditional commercial banks, shadow banks are unregulated and not subject to traditional banking regulations. (Photo: Bank Exterior via Shutterstck; Edited: LW / TO)

Prior to the 2008 financial crisis, the Federal Reserve had an important role – to solely act as a “lender of last resort” to traditional commercial banks. But during the crisis, the financial support was extended to many non-banking firms like money market mutual funds, the commercial paper market, mortgage-backed securities market and the tri-party repo market. Besides the extensive lending, non-commercial banks (also known as shadow banks) like Bear Stearns and Lehman Brothers were first to fail, triggering one of the worst financial crises across the world.

A shortage of short-term bank debt, a lack of liquidity in the commercial paper market and a sudden drop in confidence in the money market mutual fund industry initiated the crisis. Moreover, shadow banks helped in generating low-quality loans to investors seeking higher returns. All these financial products were traded through a network of financial institutions as part of the “shadow banking system.”

The US accounted for the largest shadow-banking sector, with $14.2 trillion in 2014.

Economist Paul McCulley, in his 2007 speech at the Annual Financial Symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming, coined the term “shadow bank.” Traditional commercial banks have been the driving force for creating liquidity in the economy. They accept the illiquid liabilities of both nonfinancial and financial entities for their own liquid liabilities and have access to the emergency funding of the Federal Reserve.

The shadow banking system, in contrast, introduced activities that generated liquidity through capital markets without public guarantees and provided access to the central bank as the “lender of last resort.” Unlike traditional commercial banks, shadow banks are unregulated and not subject to the traditional banking regulation system. This means that they cannot borrow in an emergency from the Federal Reserve, unlike traditional banks. The reason they are called shadow banks is because they remain uninsured under the Federal Deposit Insurance Corporation (FDIC), or roughly speaking, they remain in the shadows of the traditional banking system.

The Increasing Size of Shadow Banking in the US

Investment banks, structured investment vehicles, hedge funds, non-bank financial institutions, money market funds, mutual funds and exchange-traded funds are all a part of the shadow banking system and are not required to maintain any reserves or emergency capital. “No regulations” in a “regulated environment” could be the biggest worry of the shadow banking system. Often beyond the control of regulators and monetary policy, shadow-banking activities can resort to risky lending. According to the New York Fed, shadow banks have “increased the fragility of the entire financial system.” While the total of non-bank financial intermediaries decreased immediately after the 2008 financial crisis, the number of shadow banks have picked up in recent years.

The vulnerabilities of the traditional banking system to the unregulated risks undertaken by the shadow banking system continue to threaten the financial system in 2016. According to the Financial Stability Board’s Global Shadow Banking Monitoring Report 2015, the United States accounted for the largest shadow-banking sector, with $14.2 trillion in 2014. The figure is more than one-third of global shadow banking assets, and represents 82 percent of the nation’s GDP.

With more than 80 percent of shadow banking activities residing in the advanced economies of North America, Asia and northern Europe, shadow banking could be one of the biggest threats to the current financial system. The report identifies the difficulty in assessing the amount of risk involved due to the lack of detailed data. The Financial Stability Board, an international board that monitors the global financial system, said the shadow-banking sector posed a huge risk of $36 trillion across 26 jurisdictions across the world in 2014.

The Dodd-Frank Act

Introduced in 2010, the Dodd-Frank financial regulations have been strict in reforming the “traditional part” of the banking system, but the regulations of shadow banks remain neglected. Along with many other rules, the big banks must maintain higher capital requirements and adhere to annual stress tests conducted by the Federal Reserve. But the tightening of commercial banks through banking regulations has encouraged a shift toward shadow banking.

In 2016, while traditional banks face the strict regulations of Dodd-Frank and Basel III (capital restrictions imposed on banks by the Bank for International Settlements to restore financial stability), shadow banks remain largely unmonitored and deeply entwined with the financial system. Federal Reserve Gov. Daniel Tarullo said in a speech in November 2015 that there is a possible risk in the financial stability “from activities mostly or completely outside the ambit of prudentially regulated firms.” He added, “Shadow banking is not a single, identifiable ‘system,’ but a constantly changing and largely unrelated set of intermediation activities pursued by very different types of financial market actors. Indeed, the very rigor of post-crisis reforms to prudential regulation may create new opportunities for such activities.” While traditional commercial banks may have benefitted from the Dodd-Frank law, large sections related to shadow banking remain largely neglected.

Recently in an op-ed for The New York Times, Democratic presidential hopeful Hillary Clinton laid down her plans to discipline Wall Street. Among her suggested reforms was the introduction of a new fee on high-frequency trading and reinstatement of rules “governing risky credit swaps and derivatives at taxpayer-backed banks.” She vowed to strengthen the Volcker Rule (a rule that prohibits an insured depository institution from engaging in proprietary trading) by “closing the loopholes that allow banks to make speculative gambles with taxpayer-backed deposits.”

She also has called for a new risk fee to be imposed on the nation’s largest banks. But while the Volcker Rule tries to separate banking activities from proprietary trading, interestingly, it excludes this distinction for non-banking financial companies. Hence, shadow banks continue to operate unregulated, without being subjected to any such prohibition under the Volcker Rule.

The Glass-Steagall Act

In order to address the issue of shadow banks, many politicians have been pushing for the restoration of the Glass-Steagall Act. Prior to the Great Depression in the 1930s, commercial banks were blamed for getting very speculative and greedy, since they were not only investing their assets, but also buying new issues for resale to the public. This led to a collapse of the banking system, which slowly became irresponsible and chaotic. One of the functional reforms that came in the form of banking regulations was called the Glass-Steagall Act, and it clearly outlined the objective of the banks.

The proposal was to limit their activities by separating commercial and investment bank functions. The underlying belief of the Glass-Steagall Banking Act of 1933 was that it would reduce risk and create a healthier financial system. Under the Glass-Steagall Act, institutions were given a year to decide whether they would specialize in commercial or investment banking. This Depression-era law was in place for 60 years until Congress and President Bill Clinton repealed it in 1999 under the Gramm-Leach-Bliley Act.

The elimination of the Glass-Steagall Act under the Clinton administration happened after many banks lobbied to remove the restrictions imposed by the act. Supporters of Gramm-Leach-Bliley believed that Glass-Steagall had worked post-Depression and it was time to remove certain restrictions on banks. President Clinton agreed that the act was “no longer appropriate to the economy in which we live. It worked pretty well for the industrial economy … But the world is very different.”

The repeal allowed banking activities to combine with non-banking activities. Glass-Steagall had helped in creating a safety net for commercial banks and allowed the central bank to act as a lender of last resort to commercial banks. But the repeal of Glass-Steagall blurred the distinctive lines between regulated banking functions and shadow banking functions.

During a policy address on January 5, 2016, Sen. Bernie Sanders said, “Shadow banks did gamble recklessly, but where did that money come from? It came from the federally insured bank deposits of big commercial banks – something that would have been banned under the Glass-Steagall Act.” The Glass-Steagall Act has taken center stage in many 2016 presidential debates with Sen. Bernie Sanders and former Maryland Gov. Martin O’Malley supporting the “21st Century Glass-Steagall Act,” an updated version of the 1933 law, which aims to reduce the likelihood of future crises by clearly separating traditional banking activities like savings and checking from riskier, non-banking activities like insurance, swaps dealing, and hedge fund and private equity activities.

Estimating the size of shadow banking is difficult to quantify for the simple reason that many of the entities do not report to any government regulators and therefore remain outside the purview of lawmakers. The growing size of shadow banks remains a threat to the financial system as long as they are unregulated. The matter worsenswith the integration of commercial and investment banking activities as financial holding companies actively facilitate the growth of shadow banks.

In 2016, even with strict regulations under the Dodd-Frank Act, shadow banks remain highly leveraged (promising higher returns but with outsized risk) and wholly unregulated. More control of this unregulated section of the financial system is necessary to achieve accountability and transparency in the banking system. Addressing the issue of shadow banks will not only curb the risk associated with these unregulated banks, but also it will tackle the ongoing problem of financial institutions being “too big to fail.”