The Shadow Banking Charade

Abstract

Shadow banking emerged in the regulated banking system in the 1980s and 1990s when the traditional banking model became outmoded. Banking regulators encouraged shadow banking as the only way to preserve banks as viable entities in the financial system. They did not call it “shadow banking,” but rather treated it as part of the business of banking and extolled its benefits. Not until the financial crisis occurred did regulators begin the illusion of shadow banking as something sinister outside the regulated banking system. In adopting the shadow banking mythology, banking regulators deceived themselves as to the true nature of the forces that destabilized the financial system and misinformed policymakers in Congress. Now, having gained new powers to rid “systemic risk” anywhere in the financial system, they are seeking to uproot shadow banking competitors of banks that operate outside the regulated banking system. Chief among their targets is the money market fund industry, notwithstanding that money market funds are highly regulated and bear none of the key risk factors of shadow banks. This paper urges regulators to take a more introspective look at shadow banking as an invention of their own making within the regulated banking system and to avoid nullifying the positive aspects of shadow banking in their financial reform efforts.