Shadow Banking

Shadow banking. The name alone sounds ominous -- like some dangerous phantom biding its time, waiting for the perfect moment to leap from its hiding place to do its deadly work.

On a financial level, that metaphor actually works pretty well.

The shadow banking system does exist in the shadows, away from the spotlight of regulation we've come to expect banks to operate within. And given the right conditions, it could leap unexpectedly from its dark, financial hiding place and bring the U.S. economy to its knees, just like it nearly did in 2008.

An Honor We'd Rather Not Hold

What's bringing this issue to the forefront again is a new report by the Financial Stability Board, an international financial-standards advisory group. It cites that assets held in the global shadow banking system hit a new high last year: $67 trillion, which comes out to about half the world's total banking assets.

In the report, the FSB formally describes the shadow banking system as "credit intermediation involving entities and activities outside the regular banking system." Translated into English, this means the act of borrowing, lending, or otherwise shifting of money around by financial institutions that aren't subject to regulation, like hedge funds. It can also refer to traditional banks operating in largely unregulated arenas such as credit-default swaps.

America's portion of this $67 trillion in global assets is $23 trillion. In terms of total share, that's a decrease from 44 percent in 2005 to 35 percent in 2011 -- still enough to give the U.S. the dubious honor of having the world's largest shadow banking system, and more than enough to put the entire U.S. economy at risk of another credit freeze.

That's the danger here: Without the smooth flow of cash and credit, the lifeblood of any free-market system, economic life grinds to a halt.

What Refrigerators and Lehman Brothers Have in Common

If banks aren't lending to consumers, there's no one to buy Ford (F) cars, General Electric (GE) refrigerators, and Apple (AAPL) iPhones that keep those companies in business. And if banks aren't lending to other businesses, when companies like Starbucks (SBUX) need to replace its aging fleet of latte machines or Southwest Airlines (LUV) its aging fleet of 737s, they won't be able to borrow the capital to do so.

What happened in the fall of 2008 is that banks stopped lending to other banks -- part of this shadow banking system. The now-failed Lehman Brothers was then very dependent on the interbank lending market (known to bankers as the "repo market") to fund its day-to-day operations. But as fears grew that the Wall Street titan was overexposed to defaulting mortgage debt, other banks stopped lending to it. As a direct result, Lehman Brothers went bankrupt.

Once that happened, not only did the other big banks stop lending to each other out of fear they might go bankrupt if they didn't hang on to every last drop of capital, they stopped lending to consumers and businesses, as well, beginning the economic chain reaction described above.

This is the point where the Federal Reserve and Congress stepped in to bail out the banks: not only to ensure that those that made it through the crash had enough capital on their balance sheets to survive, but also to ensure they felt secure enough to begin lending to consumers, businesses, and each other again.

$67 Trillion and Counting

From 2002 to 2007, the size of the shadow banking system grew from $26 trillion in total global assets to $62 trillion. After a slight decline in 2008, the system began to grow again, leaving it at the $67 trillion mark it stands at today.

Since the crash, there's been a vast amount of regulation aimed at addressing the shortfalls of the regular banking system -- like Dodd-Frank and Basel III -- but nothing to seriously curb the growth of the shadow banking system.

Naturally, the Financial Stability Board is calling for increased regulatory oversight: "The FSB is of the view that the authorities' approach to shadow banking has to be a targeted one ... to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like risks to financial stability." Whether or not that will actually happen remains to be seen.

Money may not make the world go around, but it definitely makes goods and services circle the globe, which keeps businesses running, people employed, and taxes flowing into government coffers for essential services. As the FSB report argues, the continued lack of regulation in the shadow banking system puts all of that at risk.

John Grgurich is a regular contributor to The Motley Fool. Follow John's dispatches on Twitter @TMFGrgurich.




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