The Rise of Shadow Banks and the Repeal of the Glass-Steagall Act [View all]

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The Rise of Shadow Banks and the Repeal of the Glass-Steagall Act

Wednesday, 13 January 2016 00:00
By Deena Zaidi, Truthout | News Analysis


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."

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. ................(more)

http://www.truth-out.org/news/item/34387-the-rise-of-shadow-banks-and-the-repeal-of-the-glass-steagall-act