Shadow Banking: Post-Crisis, Risks Remain

Photograph by Brent Lewin/Bloomberg

1970 The Reserve Fund, the first money-market mutual fund, is launched by financial consultants Bruce Bent and Henry Brown.

Shadow banking isn’t shadowy like the illicit, underground economy. It’s shadowy like Me and My Shadow—attached to regular banking at the heels and doing all of the same things at the same time. Want to borrow money? You can get a loan from a bank—or you can do it the shadow way in the “repo” market by selling some Treasury bonds and promising to buy them back in a week for a slightly higher price, which represents the interest. Want to save money? You can deposit your cash in a bank—or you can do it the shadow way by, say, investing in a money-market mutual fund or taking the other side of one of those repo transactions.

Shadow banking took a while to make itself understood. Three years in, the Reserve Fund had only $1 million in assets. Then the New York Times wrote about it in 1973, and the funds began to pour in. Paul Samuelson, the Nobel laureate, was so impressed by the invention of Bent and Brown that he said they deserved a Nobel of their own.

Variations on the theme quickly followed. In 1977 Merrill Lynch, Pierce, Fenner & Smith introduced a money-market mutual fund that you could tap by writing checks or using a credit card. Banks were outraged by the challenge to their core business. Then came repo, short for repurchase agreement. Securitization is also part of the shadow banking system. You don’t need to ask a banker for a mortgage anymore. You can go to a finance company that will sell your loan to a securitizer, who will pool it with others, create a security, and sell it in China. Your monthly principal and interest payments are going to Shanghai now.

It wasn’t until 2007 that shadow banking acquired its name, from Paul McCulley, the chief economist of Pacific Investment Management Co. That belated recognition came one year before disaster. Regulators knew how to stop runs on ordinary banks but had no tools to prevent runs in the lightly supervised shadow banking system. The (renamed) Reserve Primary Fund, which was still one of the largest money-market mutual funds, held $785 million of the debt of Lehman Brothers in September 2008. Shareholders pulled their money out when Lehman declared bankruptcy, the fund failed, and panic spread through the world financial system. Bent was cleared of wrongdoing, but his son, Bruce Bent II, was found negligent by a jury on a single claim of violating securities law.

Shadow banking survived the damage to its reputation. Its share of global financial assets slipped from 26 percent to 23 percent and has since rebounded to 25 percent, according to data compiled by the Financial Stability Board, an international body of regulators. And regulation aimed at making the financial system safer—such as the Dodd-Frank Act and the Basel bank capital rules—only partially affected the shadow banking system. Daniel Tarullo, the regulatory point person on the Federal Reserve’s Board of Governors, warned in a speech last year that risks remain and “a more comprehensive reform agenda” is needed.

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