by John Grgurich
November 20, 2012
John Grgurich is a regular contributor to
The Motley Fool.
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Shadow banking. The name alone sounds ominous - like some dangerous phantom biding its time, waiting for the perfect moment
to leap from its hiding place to do its deadly work.
On a financial level, that metaphor actually works pretty well.
The shadow banking system does exist in the shadows, away from the spotlight
of regulation we've come to expect banks to operate within.
And given the
right conditions, it could leap unexpectedly from its dark, financial hiding
place and bring the U.S. economy to its knees, just like it nearly did in
An Honor We'd Rather Not
What's bringing this issue to the forefront again is a new report by the
Financial Stability Board, an international financial-standards advisory
It cites that assets held in the global shadow banking system hit a
new high last year: $67 trillion, which comes out to about half the world's
total banking assets.
In the report, the FSB formally describes the shadow banking system as,
"credit intermediation involving entities and activities outside the regular
Translated into English, this means the act of borrowing,
lending, or otherwise shifting of money around by financial institutions
that aren't subject to regulation, like hedge funds.
It can also refer to
traditional banks operating in largely unregulated arenas such as
America's portion of this $67 trillion in global assets is $23 trillion. In
terms of total share, that's a decrease from 44 percent in 2005 to 35
percent in 2011 - still enough to give the U.S. the dubious honor of having
the world's largest shadow banking system, and more than enough to put the
entire U.S. economy at risk of another credit freeze.
That's the danger here: Without the smooth flow of cash and credit, the
lifeblood of any free-market system, economic life grinds to a halt.
What Refrigerators and
Lehman Brothers Have in Common
If banks aren't lending to consumers, there's no one to buy Ford (F)
cars, General Electric (GE)
refrigerators, and Apple (AAPL)
iPhones that keep those companies in business.
And if banks aren't lending
to other businesses, when companies like Starbucks (SBUX)
need to replace its aging fleet of latte machines or Southwest Airlines (LUV)
its aging fleet of 737s, they won't be able to borrow the capital to do so.
What happened in the fall of 2008 is that banks
stopped lending to other banks - part of this shadow banking
The now-failed Lehman Brothers was then very dependent on the
interbank lending market (known to bankers as the "repo market") to fund its
day-to-day operations. But as fears grew that the Wall Street titan was
overexposed to defaulting mortgage debt, other banks stopped lending to it.
As a direct result, Lehman Brothers went bankrupt.
Once that happened, not only did the other big banks stop lending to each
other out of fear they might go bankrupt if they didn't hang on to every
last drop of capital, they stopped lending to consumers and businesses, as
well, beginning the economic chain reaction described above.
This is the point where the Federal Reserve and Congress stepped in to bail
out the banks: not only to ensure that those that made it through the crash
had enough capital on their balance sheets to survive, but also to ensure
they felt secure enough to begin lending to consumers, businesses, and each
$67 Trillion and
From 2002 to 2007, the size of the shadow banking system grew from $26
trillion in total global assets to $62 trillion.
After a slight decline in
2008, the system began to grow again, leaving it at the $67 trillion mark it
stands at today.
Since the crash, there's been a vast amount of regulation aimed at
addressing the shortfalls of the regular banking system - like Dodd-Frank
and Basel III - but nothing to seriously curb the growth of the shadow
Naturally, the Financial Stability Board is calling for increased regulatory
"The FSB is of the view that the authorities' approach to shadow
banking has to be a targeted one... to ensure that shadow banking is
subject to appropriate oversight and regulation to address bank-like risks
to financial stability."
Whether or not that will actually happen remains to
Money may not make the world go around, but it definitely makes goods and
services circle the globe, which keeps businesses running, people employed,
and taxes flowing into government coffers for essential services.
As the FSB
report argues, the continued lack of regulation in the shadow banking system
puts all of that at risk.