The Process of Shadow Banking

Shadow Banking Explained

Banks deal with billions of dollars daily, much of which are guaranteed by governments, but are subject to some of the most stringent laws and regulations in the world.

These large dollar amounts makes figuring out ways to bend or avoid those stringent laws extremely profitable.

Companies that do so are often referred to as taking part in the shadow banking system.

The group of companies and markets that carry out traditional banking activities outside of the traditional banking regulatory framework.

Shadow Banking Made Easy

In the United States, a bank is a company that takes demand deposits from savers and then loans that money back out to borrowers.

Savers are OK with this because the FDIC guarantees those deposits.

Even if the borrower does not repay the bank, the US government will make sure the saver gets 100% of their money back.

This guarantee comes at a price though; banks are limited in how big of investments they can make, who they can make them to and what type they can be; often having to pass on the most lucrative of opportunities.

Exceptions of Shadow Banking

If a company does not take demand deposits, they are not subject to those rules though.

Hedge funds, private investors and private equity funds fit this category.

The entities raise the majority of their cash through loans, bonds and issuing commercial paper; not demand deposits.

Shadow Banking Purpose

The shadow banking system provides market liquidity in transactions that only involve professional investors; they do pose some major risks though, some of which lead to the 2008 financial crisis.

For example:

  • Shadow banks do not have to report their internal accounting figures to the government, meaning it is harder to track and monitor them.
  • Shadow banks do not have access to the Federal Reserve’s emergency lending window, meaning that in times of crises and market tightening, their cash sources will dry up quickly.