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Economist Paul McCulley first used the phrase “shadow banking system” in 2007 at a financial conference. In his speech, he defined the shadow banking system as financial institutions that do not take deposits in the tradition sense.

The types of entities that make up the shadow banking system include hedge funds, special purpose entities, structured investment vehicles and mutual funds. While these shadow banks do accepts funds, and also borrow money, they do so in a way that does not subject them to government banking regulations.

Shadow banks make most of their money by acting as intermediaries between large borrowers and large lenders. They earn their revenue from interest rate spreads and the fees they charge for their services. It may sound simple, but in fact, it is a very complicated system involving complex investments such as derivatives, asset-backed securities, repurchase agreements, credit-default swaps and other structured securities.

The shadow banking system has come under increased scrutiny since the financial meltdown of 2008.  Since these entities do not take deposits like commercial banks, they are not subject to the same type of regulations, such as capital requirements. This permits the shadow banking system to take on more risk. Many point to this unregulated ability to take on risk as a significant cause of the financial meltdown.

Both in the U.S. and worldwide, the shadow banking system is significant. Some estimates claim it comprises 25% to 30% of the global financial system.

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