Shadow Banking - Introduction

Shadow banking activities consist of credit, maturity, and liquidity transformation that take place without direct and explicit access to public sources of liquidity or credit backstops. These activities are conducted by specialized financial intermediaries called shadow banks, which are

bound together along an inter-mediation chain known as the shadow banking system.

In the shadow banking system, credit is intermediated through a wide range of securitization and secured funding techniques, including asset-backed commercial paper (CP), asset-backed securities (ABS), collateralized debt obligations (CDOs), and repurchase agreements (repos).

While we believe the term “shadow banking,” coined by McCulley (2007), to be a somewhat pejorative name for such a large and important part of the financial system, we have adopted it for use here.

Prior to the 2007-09 financial crisis, the shadow banking system provided credit by issuing liquid, short-term liabilities against risky, long-term, and often opaque assets. The large amounts of credit intermediation provided by the shadow banking system contributed to asset price appreciation in residential and commercial real estate markets prior to the financial crisis and to the expansion of credit more generally.

The funding of credit through the shadow banking system significantly reduced the cost of borrowing during the run-up to the financial crisis, at the expense of increasing the volatility of the cost of credit through the cycle.

In particular, credit intermediaries’ reliance on short-term liabilities to fund illiquid long-term assets is an inherently fragile activity that can make the shadow banking system prone to runs. During the financial crisis, the system came under severe strain, and many parts of it collapsed. The emergence of shadow banking thus shifted the systemic risk-return trade-off toward cheaper credit inter-mediation during booms, at the cost of more severe crises and more expensive intermediation during downturns.