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Dallas Fed: "Shadow Banking System" Continues to Put Financial System at Risk

For immediate release: November 29, 2012

DALLAS—The “shadow banking system” appears poised to grow “considerably and dangerously if it does not acquire the necessary market discipline to shape risk-taking activities,” according to the latest issue of the Federal Reserve Bank of Dallas’ Staff Papers.

Staff Papers can be found at http://www.dallasfed.org/assets/documents/research/staff/staff1203.pdf

The new issue of Staff Papers, “Understanding the Risks Inherent in Shadow Banking: A Primer and Practical Lessons Learned,” written by David Luttrell, Harvey Rosenblum and Jackson Thies, serves as a primer on the complex shadow banking system and provides a narrative of how the financial system froze during the crisis of 2007–09.

The shadow banking system is made up of various avenues of credit outside the traditional banking system, according to the authors. Shadow banking is distinguished from traditional banking by the absence of explicit public sector backstops, leaving shadow banking activities susceptible to runs.

“The largest securities dealers, investment banks, finance companies and asset managers that dominate capital markets are actors in the wholesale funding and securitization that are core to shadow banking,” the authors write.

At its peak in 2008, the U.S. shadow banking system had about $20 trillion in U.S. liabilities, compared with commercial banks’ $11 trillion, the authors note.

Shadow banking activities are intricately woven into the fabric of modern banking and large bank holding companies (BHCs) in the United States, the authors say. The four most complex BHCs each have more than 2,000 legal subsidiaries in at least 50 countries, and the majority of those subsidiaries engage in shadow banking activities.

“In this case, bigger does not necessarily mean better: it may mean too big and too complex to manage,” the authors state. “The benefits of size and scope that accompany BHC bigness come with an enormous cost: The U.S. government safety net is stretched far beyond its intended purpose of protecting the U.S. payments system.”

Current financial reform efforts in the U.S. should encourage the elusive concept of good banking, the authors say. An important first step is credible elimination of the belief that large financial conglomerates will be supported by the public safety net in times of stress.

“Assuming the government will backstop large financial firms is unacceptable,” the authors write.

Luttrell is a senior economic analyst and coordinator of economic and financial analysis, Rosenblum is executive vice president and director of research and Thies is a former senior research analyst at the Federal Reserve Bank of Dallas.

 

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Media contact:
Alexander Johnson
Phone: 214-922-5288
Email: alexander.johnson@dal.frb.org

 

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