Banks usually take deposits from customers, invest them, and lend out excess money, reporting the results to the public. However, there is a whole other, larger banking industry: shadow banking.

These institutions lend and invest money between banks and financial entities. The industry has been estimated by the trans-national Financial Stability Board of being worth more than $67 trillion.

In comparison, the world’s gross domestic product is estimated to be about $72 trillion by the World Bank.

And as opposed to regular banking activity, shadow banking falls almost entirely outside of banking regulation.

What shadow banking is

Institutions involved in shadow banking include so-called non-bank financial intermediaries, such as hedge funds, money market funds, and “special purpose entities (SPEs),” companies that are created for banking outside of the bank structure, according to a paper by Steven Schwarcz, founder of Duke University’s Global Capital Markets Center.

It also includes regular banks who use SPEs to conduct shadow banking activities without having to report them on their balance sheets, according to Bloomberg.

While some academics argue that shadow banking only includes institutions built for that purpose, others such as Schwarcz argue that it includes the entire chain of intermediaries that assist the lending between banks and non-banks.

How they developed

The term “shadow banking” was coined in 2007 by economist Paul McCulley (according to Schwarcz), referring to the “alphabet soup” of levered non-investment companies hidden behind obtuse acronyms. A levered company uses borrowed capital to increase potential gains (and losses).

They grew to prominence during the 1970s, as banks sought ways to gain the profits of regulated banks while also dodging regulation, according to McCulley.

Their growth exploded in the 2000s, both because technology made the transfer of wealth much easier, and because increased regulation increased costs and gave banks incentive to find cheaper ways of doing business, Schwarcz says.

And while the industry took a huge dent in 2008 with the financial crisis, it has since been on the rise again.

The role shadow banks play in the global economy

Shadow banks can contribute significant value to the economy by reducing transaction costs, thereby making banks more efficient, Schwarcz says.

They also increase financial decentralization, which can increase consumer welfare by allowing them to tailor their investment products to their preference.

However, the presence of unregulated, decentralized financial institutions almost definitely adds to systemic risk, meaning the global economy is more likely to lead to a wide-ranging failure as witnessed with Lehman Brothers in 2008, the FSB says.

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