Shadow Banking In US Is Only Slightly Safer Than It Was Before The Financial Crisis

The shadow banking system in the US is 180% larger than the traditional banking system.  It is much larger in the US than it is in other nations which rely primarily on traditional banking.  The IMF determined that the shadow banking system in the US, which is only lightly regulated,  still contains the seeds of systemic risk to the financial system.

The shadow banking system contains a large number of institutions that operate like banks.  They borrow money short term and they lend it out to borrowers.  Unlike banks, however, which hold government guaranteed deposits,  they face the equivalent of a bank run.  Furthermore, many of them are not subject to limits on the amount of leverage that they use.  Lehman provided a good example during the financial crisis.  It borrowed money short-term,  and it used mortgage backed securities as collateral for its short term notes.  When its creditors became concerned about the safety of the collateral, they refused to provide the short term loans that Lehman used to finance its operation.  Its liabilities exceeded its assets and it became insolvent. Money market funds also operate like a bank.  They provide a higher rate of interest to depositors and they lend the funds out to borrowers.  One of the largest money market funds was a provider of short term loans to Lehman.  The deposits were not insured and money market funds faced a "bank run".  Around $300 billion was withdrawn from the money market funds which also provide credit to large businesses.  The government had to guarantee the deposits held by money market funds to stop the withdrawals.

The financial crisis in the US, precipitated by the shadow banks, quickly spread to banks in Europe.  Many of the banks purchased the mortgage backed securities from the shadow banks in the US.  They provided an above market rate of return for AAA rated assets.  Moreover, the banks did not have to hold capital against AAA rated securities.  When the market value of those assets declined many banks had to raise capital to cover their loses.  The capital problem was compounded by the decline in value of sovereign debt held by the banks.  Since the debt had a AAA rating they had not reserved capital as cushion against the decline in value of those assets. 

Much has been done in the US to reduce the risk level of the banking system.  Less has been done to reduce the systemic risk in the shadow banking system.