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Time to Shine Light on the Shadow Banking System

FDIC Chief Sheila Bair today told the the Financial Crisis Inquiry Commission that the swelling "shadow banking" system was a major cause of the financial crisis and that it must be more tightly regulated to avert future meltdowns.
"Many of the products and services of the non-bank financial institutions that comprised the shadow banking system competed directly with those provided in the traditional regulated banking system," she said during her appearance before the panel. "Eventually, the largest bank and thrift holding companies expanded into the shadow banking system by incorporating products and services into their own more lightly regulated affiliates and subsidiaries. The migration of essential banking activities outside of regulated financial institutions to the shadow banking system ultimately lessened the effectiveness of regulation and made the financial markets more vulnerable to a breakdown.
In other words, many financial services passed from the light, where they were provided by ordinary banks, into the opaque, unregulated gloom, where they were provided by investment banks, hedge funds, private equity firms and other nonbank entities.

Yet after drawing intense scrutiny following Wall Street's implosion in 2008, shadow banking has largely gone off radar in recent months. Attention shifted to other pain points, including the ongoing commercial real estate bust and whether bankers do "God's work."

That's a mistake. The fault line in financial services runs directly along the border between supervised and unsupervised activities. As Bair noted, it's no accident that the crisis affected big nonbank lenders first. They operated in the dark, even to themselves. Such firms were highly leveraged -- far more than banks -- and they took bigger risks.

The emergence of shadow banking over the last few decades also reflects a basic feature of contemporary finance -- the integration of banking, and especially the use of securitization, with the global capital markets. That reality isn't going away. Unless we get it under control, our efforts to cage, if not slay, the dragons of risk, will fail.

Global financial regulators are hammering out new rules aimed at cracking down on the shadow banking system. But those will go nowhere without the U.S. And here the effort runs into a potentially imposing roadblock -- the government's push to bring the capital markets back up to speed. Will the White House and Treasury Department back an international move to tighten restrictions on nonbank lenders when our elected officials are desperate to get loans flowing? Stay tuned.