Shadow Banking System

By the time the subprime financial shock hit in summer 2007, the machine was tranching and distributing trillions of dollars in securities to investors across the globe. Securitization's financial web was expanding exponentially, as was its dizzying complexity. Yet policymakers thought this was precisely securitization's most significant strength. The risks involved in making a loan were no longer concentrated within any one financial institution; rather, they were spread across the entire global financial system.

Loan defaults were less likely to jeopardize the viability of any particular institution, as their financial pain would be diffused widely among many investors and institutions. Global banking regulators encouraged banks to securitize their loans, pushing the risks off their balance sheets. This attitude was codified in a series of agreements known as the Basel Accords, named for the Swiss city in which they were first hammered out.10 The most recent of these agreements, called Basel II, imposes global rules on banks regarding the amount of capital they must hold in reserve to cover loan or investment losses.

These capital requirements vary based on the expected risk of the investment if a bank holds relatively safe government bonds, for example, they are required to hold less capital to guard against loss. This is called risk-weighting, and it makes sense as long as the rules reflect the true risks of a particular asset or investment. For years, highly rated residential mortgage-backed securities, collateralized debt obligations, and similar securities were assigned relatively low-risk weights, and regulators thought they were safe.

Banks thus had a strong incentive to avoid making and keeping mortgages and other loans, and to hold mortgage-backed securities instead. Banks were happy to originate loans processing borrowers and accepting origination fees but less interested in actually funding the loans, which required them to hold more capital in reserve. Funding for loans thus came increasingly from non-bank institutions.

These institutions were a mixed bag; they included investment banks, hedge funds, money-market funds, and finance companies, as well as newly invented entities called "asset-backed conduits" and "structured investment vehicles". Together they formed a shadow banking system, which was subject to little regulatory oversight and also not required to publicly disclose much, if anything, about itself.

By the second quarter of 2007, just prior to the financial shock, the shadow banking system provided an astounding $6 trillion in credit and were rapidly closing in on that provided by traditional banks.

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Shadow Banking System

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