Eye Crosser #7: The Shadow Banking System

Who knows, maybe only the “Shadow” knows about Shadow Banking.   In the halcyon days of  U.S. radio there was a radio program called “The Shadow”.

The program, loosely adapted from the popular pulp magazine series, told the story of Lamont Cranston, a wealthy young man-about-town who used his hypnotic powers to cloud men’s minds so that they could not see him, fighting crime as an Invisible Avenger known only as The Shadow.  (archive.org)

If you would like to hear a broadcast, check out this website.

Have you heard about shadow banking?  Well, neither had I until, of course, the Great Recession descended upon us.  In actuality,  shadow banking is for real.  The Federal Reserve Bank of  St. Louis (a branch of the Federal Reserve Bank in Washington, D.C.) has written an article about it in their newsletter “The Regional Economist.” The article is entitled “Is Shadow Banking Really Banking?  This is “heavy-duty” reading material.  Some readers may not want to read the entire piece, its only six (6) pages but they are action-packed, one might say, with banking jargon and detail. There are even some graphs!

Anyway, here’s a very brief summary, just one small appetizer, not the entrée’:

  •  Shadow banking describes financial intermediation that is routed outside the balance sheets of regulated commercial banks and other depository institutions
  • size of Shadow banking was close to $20 trillion at its peak and shrank to about $15 trillion in year 2010, making it at least as big as, if not bigger than, traditional banking system
  • Shadow banking comprises a chain of intermediaries that are engaged in the transfer of funds channeled upstream in exchange for securities and loan documents that are moving downstream.
  • The deposit end of shadow banking: the Federal Deposit Insurance Company (FDIC) insures bank deposits up to $250,000.  On the other hand, demand for safe, short-term investments from large, cash-rich financial and non-financial companies for deposits over $250,000 could only be fulfilled by the shadow banking system.
  • Shadow banking allows for the process of securitization of loans by which securities are created from originated loans, e.g. auto loans, mortgage loans, student loans.
  • The Special Purpose Vehicle (SPV) are organized trusts to which seller/sponsor transfers loan documents.
  • Tranching is used by the SPV as the process by which payouts on the obligations are sliced, or tranched, into classes. The more senior-rated tranches are less risky.

Again, the above is a very short summary of the  Is shadow bank really banking? article. The shadow banking system is probably  a huge part of why the housing crisis happened. But it’s like everything else,  if it  had been used properly,  meaning more judiciously, maybe just maybe, we would not quite be in the economic position that we now have.  As we say in the computer industry, “Garbage in, garbage out.” That’s sure what seemed to  happen to the loan industry in general.


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