what is the shadow banking system 
the shadow banking system describes financial intermediaries that participate in creating credit but are not subject to regulatory oversight banks play a key role in the economy underpinning the credit system by taking money from depositors and creating new credit to make loans banks usually have to operate with plenty of scrutiny from financial regulators in their home countries and around the world shadow banks often known as nonbank financial companies nbfcs can usually operate with little to no oversight from regulators examples of shadow banks or financial intermediaries not subject to regulation include hedge funds private equity funds mortgage lenders and even large investment banks the shadow banking system can also refer to unregulated activities by regulated institutions which include financial instruments like credit default swaps understanding shadow banking systemsmost of the shadow banking sector is made up of nbfcs which fall under the oversight of the dodd frank wall street reform and consumer protection act nbfcs existed long before the dodd frank act in 2007 they were given the moniker shadow banks by economist paul mcculley at the time the managing director of pacific investment management company llc pimco to describe the expanding matrix of institutions contributing to the then current easy money lending environment which in turn led to the subprime mortgage meltdown and the subsequent 2008 financial crisis 1although the term shadow banking sounds somewhat sinister many well known brokerages and investment firms engage in shadow banking activity investment bankers lehman brothers and bear stearns were two of the more famed nbfcs at the center of the 2008 financial crisis 2as a result of that crisis traditional banks found themselves under closer regulatory scrutiny which led to a prolonged contraction in their lending activities as the authorities tightened up on the banks the banks in turn tightened up on loan or credit applicants the more stringent requirements gave rise to more people needing other funding sources and hence the growth of nonbank shadow institutions that were able to operate outside the constraints of banking regulations the shadow banking system has escaped regulation primarily because unlike traditional banks and credit unions these institutions are not allowed to take traditional demand deposits readily available funds such as those in checking or savings accounts from the public this limitation keeps them outside the scope of conventional oversight from federal and state financial regulators rather than taking deposits these entities engage in other types of financial transactions the financial stability board fsb a body of international financial authorities defines shadow banking by outlining different credit intermediation activities carried out by institutions outside the regulatory framework these include maturity transformation converting short term funds into longer term investments liquidity transformation converting cash or similar assets into investments that are harder to sell credit risk transfer relocating the risk of default on a loan from the lender to another party and leverage using borrowed money to increase potential returns 34history and breadth of shadow banking systemshadow banking institutions arose as innovators in financial markets they were able to finance lending for real estate and other purposes but did not face the normal regulatory oversight and rules regarding capital reserves and liquidity these rules are required of traditional lenders in order to help prevent bank failures runs on banks and financial crises as a result of the ability of many of these institutions to avoid scrutiny from regulators they were able to create financial instruments aimed at pursuing higher market credit and liquidity risks in their lending while avoiding the requirement to maintain the capital requirements regulators require of banks in the decade following the financial crisis of 2007 08 the shadow banking sector expanded playing a key role in meeting the credit demand unmet by traditional banks this growth came with a higher level of scrutiny from regulators because of the fallout from the financial crisis but despite this increased scrutiny the sector has continued to expand significantly 5according to the financial stability board the shadow banking system which the fsb calls the nonbank financial intermediary nbfi sector grew 8 9 in 2021 well above its five year average of 6 6 annual growth at 293 3 trillion the nbfi sector s share of total global financial assets reached 49 2 in 2021 much of this growth stemmed from investment funds with money pouring in and valuations rising as the economy recovered from its pandemic lows 6the shadow banking system s relative share of total global financial assets at the end of 2021 according to the financial stability board fsb 6with the sector holding such a large percentage of financial assets around the world it may come as no surprise that the two largest economies have high shadow banking concentrations the u s is the top holder of shadow banking assets followed by china 7 chinese financial regulators reported that as of 2019 shadow banking accounted for assets worth 12 9 trillion equal to 86 of the country s gdp or 29 of its total banking assets 8shadow banking risks and regulationsthe shadow banking industry plays a role in meeting rising credit demand in the united states although it s been argued that shadow banking s disintermediation can increase economic efficiency its operation outside of traditional banking regulations raises concerns over the systemic risk it may pose to the financial system the unregulated nature of shadow banking activities means that unlike bank deposits that are insured by the federal deposit insurance corporation fdic there is no similar level of protection for assets held by nbfcs shadow banking entities are also unable to access emergency loans from the federal reserve which is available to banks that are facing a liquidity crunch 3the reforms enacted through the 2010 dodd frank wall street reform and consumer protection act focused primarily on the banking industry leaving the shadow banking sector largely intact while dodd frank imposed greater liability on financial companies selling exotic financial products most of the non banking activities are still unregulated one area that regulators are aiming to reduce the risks posed by shadow banking is by scrutinizing the exposure of regular banks to unregulated entities and products while this stops short of regulating nbfcs reining in their connection with traditional banking entities could help limit the risk to the overall economy posed by shadow banking 3the federal reserve board has also proposed that nonbanks such as broker dealers operate under similar margin requirements as banks meanwhile outside the u s china began issuing directives in 2016 directly targeting risky financial practices such as excessive borrowing and speculation in equities 9