A Review of Shadow Banking

Traditional financial intermediaries are centralized entities brokering the flow of funds between households and borrowers. Households could certainly bypass intermediaries and directly invest in equity or debt of borrowers. However, direct finance requires dealing with well-known informational and liquidity frictions. In particular, it is usually costly to screen, select, monitor, and diversify across investment projects. Moreover, direct investments may be constrained by the need by households for liquidity: that is, the need to access funds before the investments comes to fruition, resulting in wasteful liquidation costs. Financial intermediaries exist to minimize on all of these costs. In the traditional model, intermediaries are centralized agents performing under one roof multiple roles of screening, selection, monitoring, and diversification of risk, while simultaneously providing liquidity services to the providers of funds. The simultaneous provision of these services to multiple agents through maturity, liquidity, and credit transformation provides for a better allocation of risk between households and firms. While financial intermediation facilitates more efficient risk sharing between borrowers and the suppliers of funds, it does create new risks, the most relevant one being the well-known exposure to “runs†and premature liquidation of projects when the suppliers of funds pull out en masse. Hence, financial intermediation activity is intrinsically fragile, and most importantly it carries a significant social externality, represented by the risk of systemic disruptions in the case of contagion of run events. The official sector has attempted to minimize this systemic risk through the use of its own balance sheet, by providing credit guarantees on the liabilities of these intermediaries as well as by providing contingent liquidity to these institutions from the lender of last resort. However, the risk-insensitive provision of credit guarantees and liquidity backstops creates well-known incentives for excessive risk-taking, leverage, and maturity transformation, motivating the need for enhanced supervision and prudential regulation. This traditional form of financial intermediation, with credit being intermediated through banks and insurance companies, but with the public sector standing close by to prevent destabilizing runs, dominated other forms of financial intermediation from the Great Depression well into the 1990s. Over time, financial innovation has transformed intermediation from a process involving a single financial institution to a process now broken down among several institutions, each with their own role in manufacturing the intermediation of credit. With specialization has come significant reductions in the cost of intermediation, but the motive to reduce costs has also pushed financial activity into the shadows in order to reduce or eliminate the cost associated with prudential supervision and regulation, investor disclosure, and taxes. Over the course of three decades, the shadow banking system quickly grew to become equal in size to that of the traditional system, improving on the terms of liquidity traditionally offered to households and borrowers. However, it was only a matter of time before intermediation designed to evade public sector oversight would end badly, as occurred during the post-2007-08 credit cycle. Consequently, while financial innovation is naturally associated with the more efficient provision of financial services, it is this dark side of non-traditional intermediation that has come to define shadow banking.