Shadow Banking: A New Danger Zone In The Financial System Following The Financial Crisis

Following the 2008 financial crisis, Congress passed a set of laws, Dodd-Frank, which gave federal regulators broader powers to establish rules and regulations to prevent Wall Street from causing another financial meltdown.

Among the issues which Dodd Frank supposedly addressed was the de-leveraging of banks and the reduction or elimination of the “risk taking” function of banks deemed to be central to the financial system, or “systemically” important.

Such new regulation seems to have caused a hit to banks’ profits. The risk-taking or potentially money making arms, like hedge funds and proprietary trading, were spun out of the banks.

That doesn’t mean Mom and Pop investors are living in a risk free world. Indeed, a startling recent Wall Street Journal article highlights the risks to the financial system from a growing group of banks widely dubbed as “shadow banks.”

“Shadow bank is a catch-all label for any entity that supplies credit but doesn’t fund itself with deposits as banks do,” according to the Wall Street Journal’s Greg Ip. “Shadow banks were central to the mortgage bubble. Subprime mortgages were originated largely by lightly regulated firms, bundled into securities and sold to opaque funds financed with short-term IOUs. When the subprime bubble popped, many died or shrank.”

Other financial players, including mutual funds, the longtime favorite investment of buy and hold retail investors, have become a force in the murky, “ambiguous” world of financing and credit, according to Ip.

“Mutual funds and exchange-traded funds now rival banks as suppliers of credit, in particular “leveraged loans” to highly indebted companies,” Ip reports. “Total bond-fund holdings world-wide last year totaled $9.6 trillion, up 25% from 2008, according to the IMF. Mutual funds’ leveraged loans have shot up 60% to $151 billion in the U.S., and by 223%, to $126 billion, in the Eurozone.”

“These funds also finance themselves with shareholders’ equity,” according to Ip. “But there’s a wrinkle: Open-ended funds usually allow share redemptions at the end of each day, and sometimes during the day. If shareholders redeemed en masse, the effect would be similar to a run on a bank. While the fund wouldn’t fail as a bank would, it might have to liquidate its investments.”

In other words, despite Dodd-Frank’s success in limiting risks for large institutions, there is still plenty of credit and lending risk in the financial system. Leveraged loan funds, particularly during a correction in the market, could prove to be a new danger zone.

As Ip stated: “Squeezing risk out of the economy can be like pressing down on a water bed: The risk often re-emerges elsewhere. So it goes with efforts to make the financial system safer since the financial crisis.”

While regulators have responded by tightening the oversight of some shadow banks, those institutions are wily and could simply change shape and business models to escape the oversight of regulators.

That could lead to safe banks but still plenty of high-risk financial institutions extending loans and credit. Ip concludes we may end up with safer banks but a less safe financial system.

And that’s an outcome no one wants.

Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.