In their most basic form, normal banks pursue a simple business model: they pay low interest rates to people who park their money with them, while charging higher interest rates to people who borrow from them.

The difference between the two is a bank's profit, and for hundreds of years bankers have lived well from this model. Over time, however, banks took on other tasks, such as wealth management, equity trading, or advising mergers and takeovers.

In the United States, until 1999, it was strictly forbidden for commercial banks to also conduct investment banking activities. Germany has never had this separation. In the banking profession, the investment business has long been considered more tantalizing than the commercial sector. There is less regulation and the risks are higher - but so are the profits.

Thirst for freedom

Bankers, however, forged ahead, pushing for less regulation, more risk and even higher profits. Ever since the 1970s, more and more highly complex financial instruments have been developed, which, years later, played a decisive role in triggering the 2008 financial crisis.

Even as the stock markets plummeted, shadow banking yielded high profit margins

Suddenly, debt could be bought, repackaged and sold again. Suddenly, the risk of credit defaults or interest rate fluctuations could be separated from the credit approval process and traded separately. And all of a sudden, you could bet on next year's weather.

What may sound like the feverish deliriums of crazed finance wizards actually makes economic sense, Perry Mehrling, an economist at New York's Columbia University, told the US magazine Atlantic Monthly. The idea behind it is to make financial markets work better. "As the price for risk sinks, so does the price for loans," said Mehrling.

It seemed as though all these new financial products fulfilled a basic job of the banking system: to provide capital to the marketplace. For every financing wish there was suddenly a product that fit the bill.

No objections

This explains why financial watchdogs around the world had few objections to these often obscure activities of the financial industry. And it explains why they did not intervene as these activities were increasingly transferred to outside companies, which were not really banks at all: the so-called shadow banks. These special purpose entities (SPEs), conduits, structured investment vehicles or hedge funds are just some of the more well-known names given to the operations that conduct these activities.

Shadow banking can escape regulation by going offshore

The borderline between commercial banks, investment banks and shadow banks is fluid. During the financial crisis, even the rather mundane German IKB bank, which catered to small and mid-sized businesses, founded an SPE to get a piece of the action. The big advantage was that the risky involvement did not appear on the bank's balance sheet.

As varied as the shadow banks and their activities are, they have one thing in common - they do not have to follow the rules that apply to normal, commercial banks.

"The traditional banking oversight agencies really have no idea what is going on in the shadow bank market," Martin Faust, Professor for Banking Management at the Frankfurt School of Finance and Management, told DW.

"The regulatory instruments still do not exist in order to intervene, or to even see what volumes are being juggled in these markets," says Faust.

Enormous volumes

There are, of course, estimates. The Financial Stability Board (FSB), an international organization for monitoring the global financial system, figures that the worldwide volume in the shadow bank sector was somewhere around 60 trillion US dollars in October 2011. This amount is equivalent to the gross national product of the entire world. According to FSB, shadow bank activities represent about one-quarter of all global financial transactions.

Shadow bank activities are therefore larger today than they were at the beginning of the financial crisis - with all the risks this has for the global banking system. "Shadow banks speculate, so there is a risk of bad speculation," says Professor Faust. Most of the business conducted by shadow banks is focused on so-called arbitrage deals. This involves the purchase and sale of securities, stocks and bonds which frequently have only minimal margins. "In order to earn high profits, a lot of money has to be involved," says Faust.

For these deals, the shadow banks borrow much more money than is allowed by normal banks, but with leveraged funds it is possible to earn a lot of money with relatively little capital. However, if something goes wrong, you also lose a lot of money.

"The big danger with these deals is that the respective partner could go bankrupt, as we saw with the investment bank Lehman Brothers. Then, the whole house of cards can collapse in a domino effect," Faust said.

Capital flight to shadow banks

Shadow banks are an integral part of the commercial banking system

Since the financial crisis, the rules for commercial banks in many countries have been tightened. This could be one of the reasons for the growing importance of shadow banks. EU Internal Market Commissioner, Michel Barnier, thinks that many actors in the financial markets have moved their business activities to shadow banks to avoid stricter European Union regulations. It is therefore necessary, says Barnier, to extend the EU's banking regulations to the shadow bank sector.

On the other hand, it would be quite easy for the shadow banks to sidestep the national watchdogs, says Martin Faust. "These shadow banks operate worldwide. Their headquarters are in London or New York, but also offshore in locations like the Cayman Islands or the Bahamas," he notes. Successful regulation, in his view, would only be possible if the authorities were to strengthen their international coordination.

Adair Turner, the head of the British Financial Services Authority (FSA), which regulates the industry in the UK, has called for tighter regulation of shadow banks. But, he has warned that such a move could be complicated. "A system that is so complex cannot be completely understood," Turner said last Wednesday at a lecture in London. Any regulation, he says, would have to precisely define what a shadow bank is. "The sector, at least, does not exist parallel or separate from the actual banking system; it is an integral part of it."

Author: Andreas Becker / gb

Editor: Nicole Goebel