Policy Research in Macroeconomics

Shadow banking, or why black holes are important in the global financial system

“It takes me about two hours to assemble a team of finance geeks and lawyers to devise a product or a transaction that would bypass any new rule or regulation coming our way,” said a senior French banker to me in the midst of the financial crisis in autumn 2008.

His confession captures the essence of the challenge facing the regulators and policy-makers in the aftermath of the most devastating financial crisis since the 1930s. It seems that whatever financial regulators come up with as part of post-crisis policy reform, the financial industry is likely to find a way to bypass it. Or at the very least, minimize its impact. Probably the most compelling illustration of this blunt logic of financial evolution is the phenomenon of shadow banking, a term that entered public debate in 2007 and has preoccupied regulators and finance experts ever since. 

Narrow definitions of shadow banking suggest that it is, essentially, a system of market-based (as opposed to bank-based) funding, or “money market funding of capital market lending” (Mehrling et al 2012). More inclusive concepts define shadow banking as a complex network of credit intermediation outside the boundaries of the traditional, regulated bank. It was the crisis of 2007-09 that brought the scale of shadow banking into light; or rather, made a process that had been accepted as a benign force of financial innovation and competition into a political problem. Paul McCulley, then of PIMCO, argued that “the growth of the shadow banking system, which operated legally yet entirely outside the regulatory realm “drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crises we’ve ever seen” (McCulley 2009).

Almost immediately after Paul McCulley first coined the term, it became clear that “shadow banking” was both a stroke of genius and an unfortunate choice of words. Unfortunate, because confusingly (and wrongly), “shadow” banking resonates with “shady” or underground economic activity, ascribing pejorative connotations to an essential segment of finance. Ingenious, because the continuing disputes over definitions of shadow banks matured into a wide-ranging debate among industry experts, regulators, academics and civil society. Key issues being debated include what precisely shadow banking is; which entities should be included under this umbrella and why; and what to do with this system of financial intermediation in the post-crisis economy.

Academic and policy work on shadow banking shows that over the past three or four decades, banks and financial institutions have developed what amounts to a parallel financial universe. Today, behind the facade of any major banking conglomerate, there is a plethora of entities, transactions and quasi-legal cells. Many of them are “orphaned” from the visible part of the bank by complex legal and financial operations and often embedded in offshore financial havens, yet they have become integral to the functioning of our banks. These channels and cells of credit creation have included the rather specialized and obscure entities such as special purpose entities (SPEs), special investment vehicles (SIVs)[1] and asset-backed commercial paper (ABCP)[2] but also, according to some definitions, more established institutions, such as hedge funds, money market funds and government sponsored financial institutions like the American mortgage giants, Fannie Mae and Freddie Mac.

The Financial Stability Board (FSB) puts the global size of the shadow banking system at $71tn. This accounts for, roughly, half of total banking assets globally and a third of the world’s financial system. Globally, shadow banking is predominately Anglo-Saxon, with US and UK accounting for 46% and 13% of the global shadow banking system, and Japan and the Netherlands following closely (8% each). At the same time, shadow banking is an internationally diverse phenomenon, with around 40% of credit in the emerging markets provided by the nonbanking sector (Ghosh et al 2012).  Perhaps the most unsettling fact about this data is that analysts at all levels tend to admit that current figures on shadow banking activities tend to be under-estimations.

Since the crisis erupted in 2007, research into shadow banking has progressed quite rapidly, and it is undeniable that our knowledge and understanding of this complex web of finance have vastly improved. At the same time, some major political dilemmas remain unresolved. On the one hand, shadow banking is a vital part of financial activity today. It helps banks meet liquidity needs, conduct securitization and lending functions, and accommodates a variety of economic interests, from investment banks and pension funds to high-net worth individuals and sovereign wealth funds.

On the other hand, shadow banking raises at least three problems related to financial stability. First, relying on long, complex and opaque structures of credit creation, many visible banks are able to enlarge their de facto size, often creating undetected leverage and thus, adding to the problem of “too big to fail.” Second, by netting several entities into opaque chains of credit intermediation, the shadow banking system amplifies the scope for regulatory arbitrage. Third, relying and thriving on complexity, shadow banking obscures the sources and real dimensions of systemic risk in the financial system and aggravates the problem of non-transparency of finance.

The three problems are inter-related. Complexity, Gillian Tett argues, has become a social and even cultural tool of opacity, employed by financial elites in effort to isolate themselves in “silos of silence” (Tett 2010). During the boom years and even in the wake of the crisis, professional jargon and heavy mathematics serve as barriers against transparency of the often controversial yet profitable business of financial innovation that too often, is akin to financial sabotage (Nesvetailova and Palan 2013). Ironically, though perhaps not surprisingly, in the largely self-governed financial system, this complexity would prove implosive: the increasing sophistication and precision of financial practices were mirrored by the growing ignorance about the actual developments in finance. In the midst of 2007-09 meltdown, possibly for the first time in modern economic history, regulators, senior managers and academics resorted to the concept of complexity to excuse and even justify their ignorance about the developments in the financial system in general and in their own institutions in particular (Datz 2013). 

The recognition that shadow banking – an undetected and/or opaque network of financial cells and channels – played a leading role in the global financial meltdown has served to empower national and international financial regulatory bodies. It is quite remarkable that the first generation of scholarship on shadow banking has been pioneered by the regulators themselves, with major studies and insights suggested by teams working with Zoltan Pozsar (US Treasury),Manmohan Singh (IMF), Andy Haldane (Bank of England), Adair Turner (the British FSA until 2013), Claudio Borio (BIS) and researchers in other national and international regulatory institutions. These efforts helped produce refined regulatory maps, heralded by the ground-breaking study by Zoltan Pozsar and his colleagues, then at New York Fed. In the post-2007 world, these efforts are crucial steps towards a new paradigm of financial governance (Turner 2013; Borio 2012McCulley and Pozsar 2013). Instructively, this work also shows how hopelessly obsolete and inadequate mainstream economics has become in dealing with real-life challenges (Keen 2011; Pettifor 2014).

Academic research on shadow banking in turn, reveals a shocking scarcity of conceptual and even historical knowledge of financial innovation.  Up until the crisis, financial innovation had been assumed to be driven by the demand of economic agents for new financial techniques and products (Awrey 2013). It was thus seen as a natural, organic and ultimately progressive element of capitalist development. In this general paradigm, there was little dedicated conceptual knowledge developed about financial innovation per se. At best, it was viewed as a universal engine of economic growth. At worst, financial innovation did not merit specialized academic research[3]. Current academic studies of shadow banking in turn, illustrate that secrecy, lack of transparency, complexity and opacity have become essential ingredients of today’s financial innovation, yet for reasons different from those traditionally assumed.

Perhaps the real significance of the shadow banking system, broadly conceived, is that it functions as a crucial ‘black hole’ in the global economy. Richard Murphy explains that a major misconception about financial transparency is the assumption that the secrecy world is geographically located. It is not. As he writes, “it is instead a space that has no specific location. This space is created by tax haven legislation which assumes that the entities registered in such places are ‘elsewhere’ for operational purposes, i.e. they do not trade within the domain of the tax haven, and no information is sought about where trade actually occurs… To locate these transactions in a place is not only impossible in many cases, it is also futile: they are not intended to be and cannot be located in that way. They float over and around the locations which are used to facilitate their existence as if in an unregulated either” (Murphy 2009: 2).

Therefore, while the idea of  “elsewhere”  has been paramount to the emergence of the global financial system and its key nodes,  the shadow banking system firmly linked together the notion of “elsewhere” and “nowhere” not simply for the conduct of financial transactions, but for the very process of credit creation as well (Palan and Nesvetailova 2014).

It would be useful to remember this today, when, confronted with protracted recession and lack of funding for the economy, even the more critically minded of the regulators call for the return of securitization in order to boost investment and credit flow. These calls, perhaps like no academic theory or quantitative data, confirm that shadow banking is not a paranormal development of the economy or an outcome of bankers’ misguided behavior. Shadow banking is the very infrastructure of financial innovation. Without shadow banking, finance cannot function; and that is why shadow banking, however defined, is here to stay.

It is therefore quite likely that the next (and inevitable) bout of financial instability and crisis would involve a nexus of official and shadow banking systems. It remains an open question whether the rules and safeguards erected in the aftermath of the 2007-09 crisis would suffice to minimize the costs of the next crisis.  Optimists would say that our regulators are better informed, better equipped and better staffed today than they were in say, 2000 or 2006. They are. Pessimists would remind us though that it takes a team of finance geeks and lawyers only a couple of hours to devise a product that bypasses any rule or restriction.


[1] SIVs can either be affiliated with a single banking institution, or obtain support from multiple institutions. Adrian and Ashcraft (2012) report that since 2008, SIVs have stopped operating.

[2] Commercial paper collateralized by a specific pool of financial assets. The bankruptcy remoteness of all of these entities implies that the collateral backing the ABCP is exempt from the potential bankruptcy of the institution that provides the backup lines of credit and liquidity (Adrian and Ashcraft 2012).

[3] For instance, in their survey article (2004) reviewing the state of the studies of innovation Frame and White found only two dozen empirical articles addressing financial innovation, 14 of which had been written since 2000.  As the authors observed then, to the best of their knowledge, “there are no articles attempting to rank financial institutions by their innovative tendency or to measure the effect of innovative tendency on long run market yields to the institutions’ common shares” (cited in Dew 2007: 2-3).

One Response

  1. Given the Byzantine complexity and near uselessness of Dodd-Frank, Vickers and other attempts to improve bank regulation, it’s hardly surprising that “a team of finance geeks and lawyers could bypass any new rule or regulations..”.
    And it’s not just me that says the new regulations are near useless. Numerous authorities have said as much. Just two examples: Gordon Brown in the New York Times and Alistair Darling in the Financial Times. See:



    There is actually a phenomenally simple rule that would sort this whole mess out: force all banks and other lending institutions to be funded 100% by shareholders, not depositors or bondholders who can escape being bailed in. That way its plain impossible for a bank to become insolvent.

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