Shadow Banking System: Definition, Examples, and How It Works (2024)

What Is the Shadow Banking System?

The shadow banking system describes financial intermediaries that participate in creating credit but are not subject to regulatory oversight.

Banks play a key role in the economy, underpinning the credit system by taking money from depositors and creating new credit to make loans. Banks usually have to operate with plenty of scrutiny from financial regulators in their home countries and around the world. Shadow banks, often known as nonbank financial companies (NBFCs), can usually operate with little to no oversight from regulators.

Examples of shadow banks or financial intermediaries not subject to regulation include hedge funds, private equity funds, mortgage lenders, and even large investment banks. The shadow banking system can also refer to unregulated activities by regulated institutions, which include financial instruments like credit default swaps.

Understanding Shadow Banking Systems

Most of the shadow banking sector is made up of NBFCs, which fall under the oversight of the Dodd-Frank Wall Street Reform and Consumer Protection Act. NBFCs existed long before the Dodd-Frank Act. In 2007, they were given the moniker “shadow banks” by economist Paul McCulley, at the time the managing director ofPacific Investment Management Company LLC (PIMCO), to describe the expanding matrix of institutions contributing to the then-current easy-money lending environment—which in turn led to the subprime mortgage meltdown and the subsequent 2008 financial crisis.

Although the term "shadow banking" sounds somewhat sinister, many well-known brokerages and investment firms engage in shadow-banking activity. Investment bankers Lehman Brothers and Bear Stearns were two of the more famed NBFCs at the center of the 2008 financial crisis.

As a result of that crisis, traditional banks found themselves under closer regulatory scrutiny, which led to a prolonged contraction in their lending activities. As the authorities tightened up on the banks, the banks, in turn, tightened up on loan or credit applicants. The more stringent requirements gave rise to more people needing other funding sources—and hence, the growth of nonbank, "shadow" institutions that were able to operate outside the constraints of banking regulations.

The shadow banking system has escaped regulation primarily because, unlike traditional banks and credit unions, these institutions are not allowed to take traditionaldemand deposits—readily available funds, such as those in checking or savings accounts—from the public. This limitation keeps them outside the scope of conventionaloversight from federal and state financial regulators.

Rather than taking deposits, these entities engage in other types of financial transactions. The Financial Stability Board (FSB), a body of international financial authorities, defines shadow banking by outlining different "credit intermediation" activities carried out by institutions outside the regulatory framework. These include maturity transformation (converting short-term funds into longer term investments), liquidity transformation (converting cash or similar assets into investments that are harder to sell), credit risk transfer (relocating the risk of default on a loan from the lender to another party), and leverage (using borrowed money to increase potential returns).

History and Breadth of Shadow Banking System

Shadow banking institutions arose as innovators in financial markets. They were able to finance lending for real estate and other purposes, but did not face the normal regulatory oversight and rules regarding capital reserves and liquidity. These rules are required of traditional lenders in order to help prevent bank failures, runs on banks, and financial crises. As a result of the ability of many of these institutions to avoid scrutiny from regulators, they were able to create financial instruments aimed at pursuing higher market, credit, and liquidity risks in their lending while avoiding the requirement to maintain the capital requirements regulators require of banks.

In the decade following the financial crisis of 2007-08, the shadow banking sector expanded, playing a key role in meeting the credit demand unmet by traditional banks. This growth came with a higher level of scrutiny from regulators, because of the fallout from the financial crisis. But despite this increased scrutiny, the sector has continued to expand significantly.

According to the Financial Stability Board, the shadow banking system—which the FSB calls the nonbank financial intermediary (NBFI) sector—grew 8.9% in 2021, well above its five-year average of 6.6% annual growth. At $293.3 trillion, the NBFI sector's share of total global financial assets reached 49.2% in 2021. Much of this growth stemmed from investment funds, with money pouring in and valuations rising as the economy recovered from its pandemic lows.

With the sector holding such a large percentage of financial assets around the world, it may come as no surprise that the two largest economies have high shadow banking concentrations. The U.S. is the top holder of shadow banking assets, followed by China. Chinese financial regulators reported that, as of 2019, shadow banking accounted for assets worth $12,9 trillion, equal to 86% of the country's GDP or 29% of its total banking assets.

Shadow Banking Risks and Regulations

The shadow banking industry plays a role in meeting rising credit demand in the United States. Although it's been argued that shadow banking's disintermediation can increase economic efficiency, its operation outside of traditional banking regulations raises concerns over the systemic risk it may pose to the financial system.

The unregulated nature of shadow banking activities means that, unlike bank deposits that are insured by the Federal Deposit Insurance Corporation (FDIC), there is no similar level of protection for assets held by NBFCs. Shadow banking entities are also unable to access emergency loans from the Federal Reserve, which is available to banks that are facing a liquidity crunch.

The reforms enacted through the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act focused primarily on the banking industry, leaving the shadow banking sector largely intact. While Dodd-Frank imposed greater liability on financial companies selling exotic financial products, most of the non-banking activities are still unregulated.

One area that regulators are aiming to reduce the risks posed by shadow banking is by scrutinizing the exposure of regular banks to unregulated entities and products. While this stops short of regulating NBFCs, reining in their connection with traditional banking entities could help limit the risk to the overall economy posed by shadow banking.

The Federal Reserve Board has also proposed that nonbanks, such as broker-dealers, operate under similar margin requirements as banks. Meanwhile, outside the U.S., China began issuing directives in 2016 directly targeting risky financial practices such as excessive borrowing and speculation in equities.

The Bottom Line

The shadow banking system consists of lenders, brokers, and other credit intermediaries who fall outside the realm of traditional regulated banking. Although the term "shadow banking" sounds somewhat sinister, many well-known brokerages and investment firms engage in shadow-banking activity.

Proponents of these firms argue that they provide necessary credit that is not available through traditional banking channels. Opponents say that the shadow banking sector is an unregulated risk to consumers and to the financial security of the U.S. and global economy.