Subprime Crisis Background Information - Understanding The Shadow Banking System

Understanding The Shadow Banking System

A variety of non-bank entities have emerged through financial innovation over the past two decades to become a critical part of the credit markets. These entities are often intermediaries between banks or corporate borrowers and investors and are called the shadow banking system. These entities were not subject to the same disclosure requirements and capital requirements as traditional banks. As a result, they became highly leveraged while making risky bets, creating what critics have called a significant vulnerability in the underpinnings of the financial system.

These entities also borrowed short-term, meaning they had to go back to the proverbial well frequently for additional funds, while purchasing long-term, illiquid (hard to sell) assets. When the crisis hit and they could no longer obtain short-term financing, they were forced to sell these long-term assets into very depressed markets at fire-sale prices, making credit more difficult to obtain system-wide. The 1998 Long-term Capital Management crisis was a precursor to this aspect of the current crisis, as a highly leveraged shadow banking entity with systemic implications collapsed during that crisis.

In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices.

He described the significance of these entities: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."

Nobel laureate economist Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."