Several components of the shadow banking system contributed to the breadth of the financial turmoil that began in 2007, and the magnitude of the financial panic in September 2008, according to the Financial Crisis Inquiry Commission (FCIC). applying the capital requirements in Section 171 of the Dodd-Frank Act to nonbanks). Furthermore, many of the proposed regulatory responses for shadow banking have policy trade-offs analogous to regulatory policies in banking, and some shadow banking sectors already have a financial regulatory regime (such as securities regulations). Many of these economic problems and potential policy responses are illustrated by the experiences of five shadow banking sectors (repos, nonbanks, asset backed commercial paper [ABCP], securitization, and MMFs) during 2007-2008, and by regulatory responses currently being considered. In many cases (but not all), the kind of regulation applied to securities market activities is fundamentally different from the regulation of chartered depository banks. Banking regulation is typically applied only to specific institutions, is risk-based, takes into account the linkages between banks through the payment system, and includes government emergency backstops, such as a lender of last resort and a deposit guarantor. The diversity of shadow banking activities and institutions makes it difficult to generalize; however, the degree to which debt financing in the financial system is covered by risk-based regulation, has access to emergency backstops, or can easily adapt to innovation in the provision of similar services may be influenced by regulatory choices for banking and shadow banking. Adjusting the focal point of intermediation from left to right, the first shadow banking example in Figure 1 illustrates a substitute for deposits (in this case repos), the second shadow banking example illustrates a substitute for firms with special bank charters (non-bank intermediaries), and the third row illustrates a substitute for holding loans (in this case selling loans through securitization). (B) Firms without bank charters—A firm does not have to be a chartered bank in order to borrow or lend, and luminated banking involves borrowing from depositors in order to offer and hold loans. Debt can be issued and traded through securities markets. (E) Money Market Mutual Funds—MMFs gather funds from investors in order to buy relatively low risk short-term debt in securities markets. Potential Policy Problems in Financial Intermediation

It is difficult to generalize about the policy problems of shadow banking because the same term is used to describe firms or activities that focus on different bank-like functions. Like luminated banks, shadow banks that fund themselves with short-term obligations (albeit not deposits) in order to fund longer term assets have a maturity mismatch and are also vulnerable to interest rate risk. Information asymmetries are of particular importance to those categories of shadow banking that rely on securities markets to perform bank-like functions. Shadow banking that relies on collateral can also be subject to self-reinforcing fire sales. For example, during the mortgage crisis of 2007-2009, some forms of ABCP were collateralized by the mortgage-backed securities that they funded. Regulation and Other Policy Responses to Financial Vulnerabilities

Because the term shadow banking is used to describe such a diversity of firms and practices, it would be incorrect to categorize luminated banking as regulated and shadow banking as unregulated. Securities regulation, which several categories of shadow banking involves, generally requires disclosure of material risks, but typically does not limit the risk that sophisticated securities market participants may take. Deposit Insurance

One of the fundamental problems of financial intermediation is a depositor run, which may be more likely to occur during times of financial panic. Specific Sectors of Shadow Banking

The report thus far has presented an economic framework to understand the disparate institutions and markets that are gathered under the term shadow banking. In each case, the report briefly describes the institution or market, links it to the description of financial intermediation described above, briefly discusses its experience during the financial crisis, and describes related policy concerns. Repurchase Agreements

			Description

In the context of shadow banking, a repurchase agreement is analogous to a banking deposit. First, some have suggested that nonbanks that rely on repo transactions to conduct financial intermediation similar to banks should be subject to safety and soundness regulations. Before a crisis, nonbanks with more than $50 billion in assets can be subjected to safety and soundness regulation if there is a determination of systemic risk concerns under Title I. Even smaller nonbanks can be resolved by the FDIC if there is a determination that their failure could contribute to financial instability under Title II. However, Title XI of the DFA limits the ability of the Federal Reserve to provide emergency lending to a single nonbank (as it did for Bear Stearns); rather, future emergency lending facilities would have to have more general eligibility criteria. Policy Concerns

Several policy changes have been implemented to attempt to address future problems in ABCP. The Dodd-Frank Act created a new regulatory framework for the securitization process, especially for residential mortgage securitization. Rather, MMFs are required to provide periodic disclosures like other firms funded through securities markets. Nonbanks often facilitate shadow banking by funding debt through securities markets. Whether offered by nonbanks or by banks, the creation and funding of debt is often subject to several economic vulnerabilities linked to financial intermediation, such as vulnerabilities to runs or fire-sales. However, the type of regulation that applies to shadow banking varies. Banking regulation is typically prudential (risk-based), but securities regulation typically is not.
Shadow banking refers to financial firms and activities that perform similar functions to those of depository banks. Although the term is used to describe dissimilar firms and activities, a general policy concern is that a component of shadow banking could be a source of financial instability, even though that component might not be subject to regulations designed to prevent a crisis, or be eligible for emergency facilities designed to mitigate financial turmoil once it has begun. This concern is magnified by the experience of 2007-2009, during which financial problems among nonbank lenders, and disruption to securitization (in which both banks and nonbanks participated), contributed to the magnitude of the financial crisis. This report provides a framework for understanding shadow banking, discusses several fundamental problems of financial intermediation, and describes the experiences of several specific sectors of shadow banking during the financial crisis and related policy concerns.
Shadow banking is contrasted with luminated banking, a term which the report uses to describe chartered banks that gather funds from depositors in order to offer loans that the chartered bank holds itself. Luminated banking, like all forms of financial intermediation, is subject to well-known risks, including credit risk, interest rate risk, maturity mismatch, and the potential for runs. Each sector of shadow banking is generally subject to the same problem of financial intermediation to which the sector is analogous. For example, if a sector of shadow banking such as money market funds (MMF) has investors that are analogous to depositors in luminated banking, then the potential for runs may be similar. Or, if the sector relies on collateralized loans, such as asset-backed commercial paper (ABCP), then disruptions in the market for the underlying collateral can cause fire sales that may reinforce and magnify price declines.
The regulatory regime and eligibility for emergency financial assistance for shadow banking varies from sector to sector and type of firm to type of firm. For example, the Dodd-Frank Act subjects certain large nonbank firms funded by repurchase agreements (repos) to safety and soundness regulation similar to banks. The Dodd-Frank Act prohibits emergency assistance to individual firms as was done in 2008 for Bear Stearns or AIG, but preserves the ability of the Federal Reserve to provide more generally eligible assistance to shadow banking sectors such as ABCP through the Term Asset Backed Liquidity Facility (TALF). Title II of the Dodd-Frank Act allows the FDIC to resolve the failure of any firm, including shadow banking firms, whose failure may pose a threat to financial stability.
Several components of shadow banking rely on securities markets to fund debt. These securities regulations are typically activity based, applying to all securities market participants if there is no explicit exemption. Securities regulation requires disclosure of material risks, but often does not attempt to limit the risks of firms funded through securities markets. In contrast, banking regulation sometimes applies only to firms with specific charters. Furthermore, banking regulators oversee linkages between banks, such as the payment system. Thus, debt funded through securities markets is likely to be subject to regulation no matter who does it, but that regulation is unlikely to be risk-based or to incorporate linkages between firms. Banking regulation is likely to be risk based, but to miss debt funded through securities markets.
Some policy options for shadow banking firms and markets are often analogous to policy options for depository banking or securities markets. Firms that engage in shadow banking could be subjected to safety and soundness regulation and capital requirements in order to limit risk and encourage resilience. Providers of short-term credit to shadow banks could be offered guarantees analogous to deposit insurance in order to minimize runs. Non-bank firms that rely on short-term credit to fund lending (or the holding of debt) can be made eligible for emergency lending facilities from a lender of last resort in order to address liquidity problems.
There are alternatives to the banking approach. Banks and other firms that fund themselves with substitute for deposits could be assessed higher fees to account for potential systemic costs that current market prices might not incorporate. More financial regulation could be made activity based, rather than charter based, in order to lessen regulatory arbitrage. Differences in banking regulation and securities regulation for the funding of debt could be preserved, but each separate category of regulation could be addressed where it applies.
The report analyzes five sectors of shadow banking. These sectors include (1) repos, (2) non-bank intermediaries, (3) ABCP, (4) securitization, and (5) MMFs. For each of these sectors, the report briefly defines the sector, recounts the sector's experience during the financial crisis, and outlines some related policy concerns. Each policy problem is described in the context of the general problems of financial intermediation introduced earlier in the report.