The shadow banking system is unravelling

Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self­fulfilling and destructive run on its ­liquid liabilities.

But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that ­prevent runs.

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