Instead of the big banks that are normally the focus of regulations meant to protect taxpayers and the broader economy, nonbank financial institutions known as shadow banks may pose the more immediate threat to the financial system.
It's a problem that top regulators are aware of, and one that researchers at the Federal Reserve Bank of New York highlighted Thursday as part of a larger review of issues surrounding big banks.
The term “shadow banking” refers to any financial institution that doesn't receive depository insurance or another kind of safety net from the federal government. Those include asset management firms such as BlackRock or Fidelity, government-sponsored enterprises such as Fannie Mae and many other kinds of businesses that are involved in connecting lenders to borrowers.
The Dodd-Frank law and its regulations are primarily intended to prevent taxpayers from having to bail out bank holding companies in the future. The problem is that companies just outside the regulatory net cast by Dodd-Frank may be the source of instability — and candidates for bailouts — in the future.
“Although the policy response to the growth and vulnerabilities of the financial sector has been to enhance supervision and regulation of large firms and visible financial sectors,” wrote the New York Fed study’s authors, “historically, growth has occurred mainly in areas outside the current regulatory ambit.”
In fact, shadow banking is larger than traditional banking. The New York Fed study notes it is a majority of credit intermediation:
Federal Reserve governor Daniel Tarullo, the central bank's de facto head of regulation, warned at a conference on shadow banking in November that “we must be mindful that it is not really a single system. It is immeasurably more complicated than the bank deposit system of either the 1930s or today.”
Treasury Secretary Jack Lew, in an interview with Charlie Rose in February, said the government had made progress in ending the problem of too-big-to-fail financial firms, but the question of whether any companies remain so large that they could not fail without dragging the rest of the financial system down is one that “fundamentally can only be answered in a financial crisis.”
Lew listed shadow banking as one challenge that he and other regulators know they have to address.
“As regulated institutions in the United States and around the world are becoming more closely supervised,” he noted, “there’s been a shift of resources into institutions that are outside of the traditional banking world. Which isn’t a bad thing in and of itself, unless the risk there grows to the point that it in itself creates the risk of a systemic problem.”
Former Fed Chairman Ben Bernanke drew attention to the need to address potential risks in shadow banking, money market mutual funds in particular, in a speech in May. One such firm, the Reserve Primary Fund, threatened to collapse in fall 2008, causing a run on the shadow banking system. It was at that point that the Bush administration and Bernanke established a raft of programs intended to backstop credit to the shadow banking system, some of which later became known, somewhat misleadingly, as QE1.
Regulators have issued rules intended to prevent runs on money market mutual funds and other parts of the shadow banking system. But they’re aware that shadow banks, for now, remain beyond their reach.