Shadow Banking

The global finance system is made up of a two-tier system consisting of the traditional banking system and shadow banking. Shadow banking consists of financial institutions that provide lending and banking activities done outside the scope of traditional banking; lending via auto loans, consumer loans and mortgages. Where traditional banks utilize cash deposits in order to raise capital, shadow banks sell securities on the market by means of the repo (repurchase) market where “collateral that can be rehypothecated” or traded for capital to then be repurchased at a later date. (Gorton, 14) This fact limits the amount of lending traditional banks can do leaving a void and perhaps opportunity for other financial institutions. Shadow banks fills that void by providing many services traditional banks are not able to, such as lending to a higher risk pool and providing loans at low interest rates. The shadow banking industry allowed Americans better access to cheap credit. Indeed, according to Standard and Poor’s, “the aggregate shadow-banking sector … accounted for almost 40% of total financial assets” at the peak of the financial crisis in 2008. (5)

In terms of accounting practices, money lent out by the traditional banks is also kept on their books. Shadow banks, on the other hand, do not keep the loans on their books. They rather bundle them into securities, selling them as bonds on the market. Petroff explains in The Rise and Fall of The Shadow Banking System that investors are then also able to earn a higher interest rate over Treasuries, making the securities very attractive. Those higher interest rates were based on the belief by investors that the market would continue to rise, specifically, the housing market. Furthermore, where traditional banking is highly regulated, shadow banking is unregulated. Regulations were put in place by the government as a result of various financial crises with the goal of preventing the same events in the future. Key...