Academic journal article Federal Reserve Bank of New York Economic Policy Review

Shadow Banking

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Shadow Banking

Article excerpt

* Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees.

* The banks have played a key role in the market-based financial system, particularly in the run-up to the financial crisis.

* This study describes the institutional features of shadow banks, their economic roles, and their relation to traditional banks.

* The authors suggest that increased capital and liquidity standards for depository institutions and insurance companies will likely heighten the returns to shadow banking activity.

* Shadow banking, in some form or another, is therefore expected to be an important part of the financial system for the foreseeable future.


Shadow banking activities consist of credit, maturity, and liquidity transformation that take place without direct and explicit access to public sources of liquidity or credit backstops. These activities are conducted by specialized financial intermediaries called shadow banks, which are bound together along an intermediation chain known as the shadow banking system (see "The Shadow Banking System" Online Appendix). (1)

In the shadow banking system, credit is intermediated through a wide range of securitization and secured funding techniques, including asset-backed commercial paper (CP), asset-backed securities (ABS), collateralized debt obligations (CDOs), and repurchase agreements (repos). While we believe the term "shadow banking," coined by McCulley (2007), to be a somewhat pejorative name for such a large and important part of the financial system, we have adopted it for use here.

Prior to the 2007-09 financial crisis, the shadow banking system provided credit by issuing liquid, short-term liabilities against risky, long-term, and often opaque assets. The large amounts of credit intermediation provided by the shadow banking system contributed to asset price appreciation in residential and commercial real estate markets prior to the financial crisis and to the expansion of credit more generally. The funding of credit through the shadow banking system significantly reduced the cost of borrowing during the run-up to the financial crisis, at the expense of increasing the volatility of the cost of credit through the cycle.

In particular, credit intermediaries' reliance on short-term liabilities to fund illiquid long-term assets is an inherently fragile activity that can make the shadow banking system prone to runs. (2) During the financial crisis, the system came under severe strain, and many parts of it collapsed. The emergence of shadow banking thus shifted the systemic risk-return trade-off toward cheaper credit intermediation during booms, at the cost of more severe crises and more expensive intermediation during downturns.

Shadow banks conduct credit, maturity, and liquidity transformation much like traditional banks do. However, what distinguishes shadow banks is their lack of access to public sources of liquidity, such as the Federal Reserve's discount window, or to public sources of insurance, such as that provided by the Federal Deposit Insurance Corporation (FDIC). Because the failure of credit intermediaries can have large, adverse effects on the real economy (see Bernanke [1983] and Ashcraft [2005]), governments have chosen to shield the traditional banking system from the risks inherent in maturity transformation by granting them access to backstop liquidity in the form of discount window lending and by providing a credit put to depositors in the form of deposit insurance.

In contrast to traditional banking's public sector guarantees, the shadow banking system, prior to the onset of the financial crisis, was presumed to be safe, owing to liquidity backstops in the form of contingent lines of credit and tail-risk insurance in the form of wraps and guarantees. …

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