Academic journal article Harvard Law Review

Danger Lurking in the Shadows: Why Regulators Lack the Authority to Effectively Fight Contagion in the Shadow Banking System

Academic journal article Harvard Law Review

Danger Lurking in the Shadows: Why Regulators Lack the Authority to Effectively Fight Contagion in the Shadow Banking System

Article excerpt

Financial crises can be incredibly politically destabilizing and can make life miserable for millions of people, particularly the poor and the disadvantaged, who often lack the savings to weather the storm unscathed. Yet what is often lost in debates about financial crises is that they are, in large part, creatures of law: the risky behavior at their root is possible only because the law allows it, and the crisis-response tools available to financial policymakers are determined by the legal limits on these policymakers' authority. In the wake of the 2007-2008 financial crisis, one must then ask not only what policy changes will help to avoid future financial crises, but also what legal changes will help to achieve this goal.

This Note argues that significant legal change is necessary to mitigate the systemic risk posed by the reliance of investment banks, money market mutual funds (MMMFs), and other entities in the "shadow banking system" (1) on forms of short-term funding that serve as functional substitutes for deposits. Reliance on these "deposit substitutes" makes the shadow banking system both highly profitable in good times and highly vulnerable to damaging bank run-like behavior in bad times, as demonstrated by the 2007-2008 financial crisis. Although several commentators have debated what policies will best address this risk, they have for the most part neglected whether federal financial regulatory agencies actually have the requisite authority to regulate deposit substitutes in the first place--and, this Note argues, these agencies rather surprisingly do not. Accordingly, Congress should confer upon the Federal Reserve (the Fed) the authority to regulate deposit-substitute funding, defined broadly and functionally, and if Congress fails to do so, (2) the Financial Stability Oversight Council (FSOC) (3) should request such legislation by invoking section 120(d)(3) of the Dodd-Frank Act. (4)

The Note proceeds as follows. Part I lays out the case for regulating deposit substitutes as a general matter. It explains how shadow banks' reliance on deposit substitutes for funding creates systemic risk. Part II examines potential existing statutory bases of authority for regulating deposit substitutes, concluding that financial regulators currently lack the authority to regulate deposit substitutes effectively, and that Congress should clearly establish such authority. Part III then argues that this conferral of authority should define deposit substitutes broadly and functionally to stave off attempts by shadow banks to use financial innovation to engage in harmful regulatory arbitrage. Part III concludes by arguing that this new regulatory authority should be conferred on the Fed.


The shadow banking system's reliance on very short-term liabilities makes it vulnerable to contagious runs like those that plagued the traditional banking system prior to the creation of federal deposit insurance. The potential for such contagious runs represents a systemic risk, and accordingly there is a strong case for regulating the manner in which the shadow banking system funds itself.

Though commentators often refer to the "banking system," in fact the United States has two separate banking systems, each governed by different legal regimes. The first is the traditional "depository" banking system, which is comprised of all entities that have a banking charter. This Note refers to such entities as "banks." The second is the "shadow" banking system, which is comprised of all financial intermediaries that do not have a banking charter but nevertheless offer services that are similar to those offered by commercial banks. The most obvious examples of such intermediaries are investment banks like Goldman Sachs, which in a formal legal sense are actually not "banks" at all, even if they are owned by bank holding companies. For the sake of consistency and simplicity, this Note refers to these entities as "shadow banks," even though some of them, such as MMMFs and hedge funds, bear only a passing resemblance to traditional banks in terms of their structures or investment strategies. …

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