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What is the 'Shadow Banking System'

A shadow banking system refers to the financial intermediaries involved in facilitating the creation of credit across the global financial system but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions. Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments, while examples of unregulated activities by regulated institutions include credit default swaps.

BREAKING DOWN 'Shadow Banking System'

The shadow banking system has escaped regulation primarily because it does not accept traditional bank deposits. As a result, many of the institutions and instruments have been able to employ higher market, credit and liquidity risks, and do not have capital requirements commensurate with those risks. Subsequent to the subprime meltdown in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations.

The Breadth of the U.S. Shadow Banking System

Shadow banking is a blanket term to describe financial activities that take place among nonbank financial institutions outside the scope of federal regulators. These include investment banks, mortgage lenders, money market funds, insurance companies, hedge funds, private equity funds and payday lenders, all of which are a significant and growing source of credit in the economy.

Despite the higher level of scrutiny of shadow banking institutions in the wake of the financial crisis, the sector has grown significantly, with more than $25 trillion in funds flowing through the system in 2015. Most of the activity centers around the creation of collateralized loans and repurchase agreements used for short-term lending between nonbank institutions and broker-dealers. Nonbank lenders, such as Quicken Loans, account for an increasing share of mortgages in the United States. One of the fastest-growing segments of the shadow banking industry is peer-to-peer (P2P) lending, with popular lenders such as LendingClub.com and Propser.com. P2P lenders initiated more than $1.7 billion in loans in 2015.

Who Is Watching the Shadow Banks?

Although the shadow banking industry plays a critical role in meeting rising credit demand in the United States, its operation outside of traditional banking regulations raises concerns over the financial risk it poses to the financial system. The reforms enacted through the 2010 Dodd-Frank Act focused primarily on the banking industry, leaving the shadow banking sector largely intact. While the Act imposed greater liability on financial companies selling exotic financial products, most of the nonbanking activities are still unregulated. The Federal Reserve Board has proposed that nonbanks, such as broker-dealers, operate under similar margin requirements as banks.

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