The concept of shadow banking and its implications for financial
stability
Introduction
The global financial crisis starting in 2007 revealed vulnerabilities in key parts of the financial
system that were previously overlooked or not well understood. One such area was the
development of ‘shadow banking’ – complex financial intermediation conducted through
institutions and mechanisms outside of traditional banking regulation. This essay will explore the
concept and key components of shadow banking, how it developed and how large it has
become. It will then assess the implications shadow banking poses for overall financial stability
through its interconnections with traditional banks and impact on maturity and liquidity
transformation. The essay will conclude by considering regulatory reforms aimed at addressing
the regulatory arbitrage and systemic risk created by shadow banking.
Defining Shadow Banking
There is no universally agreed definition of shadow banking, as the term encompasses a
diverse set of activities, institutions and entities. In general terms, shadow banking refers to
credit intermediation that takes place outside of the traditional banking system through various
unregulated and non-bank financial intermediaries. This includes entities conducting activities
like securitization, collateralized lending, money market mutual funds and repos. A useful
definition comes from the Financial Stability Board (FSB), who define shadow banking as “credit
intermediation involving entities and activities outside the regular banking system” (FSB, 2011).
Three key characteristics are commonly attributed to shadow banking activities according to the
FSB:
1. Maturity transformation - Many shadow banking entities fund longer-term assets with
short-term liabilities through repo markets, commercial paper or money market funds. This
exposes them to runs by liability holders.
2. Leverage - Shadow banking intermediaries typically use high degrees of financial and/or
economic leverage to generate greater returns.
3. Liquidity transformation - They collect demand deposits or other short-term liabilities from
investors that can be redeemed quickly even though their assets cannot be quickly sold or are
illiquid.
Key Shadow Banking Components
A number of specific entities and activities have developed within the shadow banking system
through various regulatory arbitrage opportunities. Among the main components are:
Securitization - The process of pooling together various types of financial assets like mortgages,
auto loans or credit cards into financial instruments which are then sold to investors. This
allowed non-bank entities to intermediate credit and transfer risk away from originating banks.
Securitization vehicles largely sat outside the regulated banking system and grew rapidly
leading up to the crisis.
Money Market Mutual Funds (MMMFs) - Open-ended mutual funds that invest primarily in
short-term, low risk instruments like commercial paper, certificates of deposit and government
securities. They offered bank-like services like transaction accounts and cheque-writing facilities
without bank regulation or deposit insurance backing.
Repos - Short-term loans whereby one party agrees to sell assets to another and buy them
back at a future date. Repos are commonly used by shadow banks to fund longer-term assets
through maturity transformation. The repo market grew enormously in the 2000s.
Commercial Paper (CP) - Short-term unsecured promissory notes issued by corporations to
fund expenses like payroll. CP issued by shadow banks was used interchangeably with MMMFs
as short-term funding sources.
Structured Investment Vehicles (SIVs) - Off-balance sheet entities that funded long-term assets
through the issuance of asset-backed CP. They relied on constant rollover of short-term
liabilities to finance assets.
Financial Guarantors - Monocline insurers who provided credit protection on mortgage-backed
securities, CDOs and CP through financial guarantees without adequate capital and modeling of
systemic risks.
Development and Scale of Shadow Banking
Shadow banking grew significantly in the pre-crisis period for a variety of reasons:
1. Regulatory Arbitrage - More stringent bank regulations from Basel I/II and minimum capital
requirements made unregulated entities more appealing. Shadow banking could intermediate
credit without holding regulatory capital.
2. Financial Innovation - New structured products enabled profitable transformation between
short-term funding/investing activities and long-term lending activities. This allowed greater
multiplication of leverage.
3. Securitization Boom - Driven by real estate bubbles, rapidly rising volumes of mortgage and
consumer debt securitization flooded global markets with AAA-rated structured products.
4. Low Interest Rates - After the 2001 US recession, sustained low rates boosted speculative
investments into high-yielding securitized assets and fueled leverage in the banking system.
By 2007, total US shadow banking liabilities were roughly equal to those of the traditional
banking sector at over $20 trillion each according to US Federal Reserve estimates. In Europe,
shadow banking assets held by institutions outside the banking system grew to around 50% of
Euro area GDP (FSB, 2012). Growth was even larger in emerging markets like China, Korea
and Mexico where shadow banking may have exceeded 100% of GDP (Ernst & Young, 2012).
This illustrated how it had become an enormous parallel banking system interconnected with
regulated banks globally.
Implications of Shadow Banking for Financial Stability
While shadow banking provided an important sources of funding liquidity and credit extension
during the pre-crisis period, its scale and interconnectedness with traditional banks highlighted
vulnerabilities that became apparent during the financial turmoil:
Procyclical Leverage - Shadow banks had largely unregulated leverage through repos, CP
issuance, ABCP conduits and off-balance sheet SIVs/CDOs. This amplified the economic cycle
by providing an abundance of credit during booms but exposed the system to deleveraging
during downturns.
Runs and Liquidity Spirals - Reliance on short-term wholesale funding left the entities highly
vulnerable to runs, as evidenced by investors rapidly withdrawing from MMMFs, repo and ABCP
markets in 2008. This created a liquidity crisis that spread to traditional banks.
Interconnectedness - Shadow banking entities were major counterparties and investors of
banks through repo lending, asset purchases and credit guarantees. When runs occurred in the
shadow system, losses spilled back onto regulated banks.
Toxic Asset Fire Sales - Forced liquidations of assets of defaulting shadow banks flooded
markets, depressed prices of securitized products, wiped out capital of monolines, and further
aggravated deleveraging and negative price spirals.
Procyclical Regulations - Banking regulations encouraged the migration of lending activities
outside of regulated institutions during the boom, only to see these non-bank intermediaries
collapse and reinforce the financial crisis. This exposed regulatory gaps and flaws in the
regulatory framework.
Opaqueness - Activities in repo, ABCP and securitization markets took place through complex
transactions without standardized disclosure requirements. This hampered monitoring,
prevented accurate risk measurement, and reduced transparency overall.
Maturity mismatches and liquidity risk transformations were exacerbated on a larger scale than
previously seen due to the tremendous growth of shadow banking entities globally which relied
on constant rollover of funding to finance longer-term and often illiquid assets. When short-term
funding markets broke down in interbank and commercial paper markets, it triggered a broader
deleveraging cycle. This transmission exacerbated the financial crisis and exposed the buildup
of systemic risks within the shadow banking system.
Regulatory Reforms
In the aftermath of the crisis, policymakers recognised the importance of addressing
vulnerabilities related to shadow banking activities. A range of reforms have since been agreed
to at the international and national levels aimed at tackling the regulatory arbitrage and closing
gaps exposed by the crisis. These include:
Stricter Regulation of MMMFs - The US introduced regulations like minimum liquidity buffers
and floating net asset values to reduce susceptibility to runs. Europe subjected MMMFs to
authorisation and supervision as alternative investment funds.
Regulation of Repo and Securities Financing Markets - International standards monitor haircuts
and re-hypothecation of collateral in repos. Minimum haircuts apply to low quality collateral.
Jurisdictions now regulate systemic repo entities.
Expanded Oversight of Non-Bank Intermediaries - Authorities in major jurisdictions now monitor
entities performing bank-like functions involving maturity/liquidity transformation. They may face
prudential standards and supervision commensurate with risks.
Enhanced Securitisation Standards - New rules mandate risk retention for originators of
securitised products to align interests. Standardised disclosure frameworks improve
transparency of securitisation vehicles.
Resolution Frameworks for Non-Banks - Authorities developed tools to wind-down non-bank
financial institutions in an orderly manner without destabilising the system, including bail-in
powers as needed.
Central Clearing of Derivatives - Mandatory central clearing of standard bilateral OTC
derivatives aimed to reduce counterparty risk and improve transparency of these markets, many
of which involved shadow banking players.
Liquidity Requirements - Basel III introduced standards like Liquidity Coverage Ratios and Net
Stable Funding Ratios to strengthen liquidity risk management at banks and limit maturity
mismatches. This aims to reduce procyclical reliance on volatile short-term wholesale funding.
Macroprudential Policies - Tools like countercyclical capital buffers and provisioning measures
aim to constrain excessive credit and leverage across the financial system including shadow
banks to reduce system-wide risks building during upswings.
Increased Data Collection and Monitoring - National regulators and international bodies collect
standardized data and conduct quantitative assessments of non-banks engaging in credit
intermediation to better understand exposures, connections and risks.
While reforms have made progress in reducing specific vulnerabilities, it remains challenging to
comprehensively regulate borderless shadow banking activities due to ongoing innovation.
Jurisdictions must cooperate globally on consistent implementation and close further arbitrage
opportunities to fully address buildup of potential systemic risk in non-bank finance. Active
monitoring is also required given shadow banking entities may evolve or migrate to unregulated
jurisdictions. Ongoing reforms are still needed to ensure appropriate oversight, transparency
and stabilisation policies extend to all areas of credit intermediation outside the traditional
banking system.
Conclusion
Shadow banking grew enormously in the decade preceding the global financial crisis as
financial innovation enabled large scale regulatory arbitrage and maturity/liquidity transformation
outside regulated institutions. By conducting core banking activities without oversight or
safeguards, it created unintended vulnerabilities in the broader financial system through
procyclical leverage, interconnectedness with regulated banks, and susceptibility to runs in short
term funding markets.
When the crisis erupted, it exposed the accumulation of neglected systemic risks within shadow
banking linkages. This amplified the severity of the crisis through fire sales of assets and
impaired liquidity in credit markets. Policymakers globally have since worked to identify these
oversights and implement reforms addressing the core weaknesses around opacity, unstable
wholesale funding, leverage, securitisation, liquidity mismatches and inconsistent regulation
brought to light.
While standards continue to evolve, full oversight of borderless and innovative shadow banking
remains a long term challenge requiring vigilance and cooperation. Constant monitoring of new
forms of regulatory arbitrage and macroprudential policies are needed to control excessive
risk-taking outside the regular banking system on both a micro and macro level. Ongoing
sustainable reform would help prevent future turbulence from building again within regulated
and unregulated sectors of the financial system alike. With proper regulations and oversight in
place, shadow banking could potentially be better harnessed to provide stable market-based
finance for the economy.
The global financial crisis starting in 2007 revealed vulnerabilities in key parts of the financial
system that were previously overlooked or not well understood. One such area was the
development of ‘shadow banking’ – complex financial intermediation conducted through
institutions and mechanisms outside of traditional banking regulation. This essay will explore the
concept and key components of shadow banking, how it developed and how large it has
become. It will then assess the implications shadow banking poses for overall financial stability
through its interconnections with traditional banks and impact on maturity and liquidity
transformation. The essay will conclude by considering regulatory reforms aimed at addressing
the regulatory arbitrage and systemic risk created by shadow banking.
Defining Shadow Banking
There is no universally agreed definition of shadow banking, as the term encompasses a
diverse set of activities, institutions and entities. In general terms, shadow banking refers to
credit intermediation that takes place outside of the traditional banking system through various
unregulated and non-bank financial intermediaries. This includes entities conducting activities
like securitization, collateralized lending, money market mutual funds and repos. A useful
definition comes from the Financial Stability Board (FSB), who define shadow banking as “credit
intermediation involving entities and activities outside the regular banking system” (FSB, 2011).
Three key characteristics are commonly attributed to shadow banking activities according to the
FSB:
1. Maturity transformation - Many shadow banking entities fund longer-term assets with
short-term liabilities through repo markets, commercial paper or money market funds. This
exposes them to runs by liability holders.
2. Leverage - Shadow banking intermediaries typically use high degrees of financial and/or
economic leverage to generate greater returns.
3. Liquidity transformation - They collect demand deposits or other short-term liabilities from
investors that can be redeemed quickly even though their assets cannot be quickly sold or are
illiquid.
Key Shadow Banking Components
A number of specific entities and activities have developed within the shadow banking system
through various regulatory arbitrage opportunities. Among the main components are:
Securitization - The process of pooling together various types of financial assets like mortgages,
auto loans or credit cards into financial instruments which are then sold to investors. This
allowed non-bank entities to intermediate credit and transfer risk away from originating banks.
Securitization vehicles largely sat outside the regulated banking system and grew rapidly
leading up to the crisis.
Money Market Mutual Funds (MMMFs) - Open-ended mutual funds that invest primarily in
short-term, low risk instruments like commercial paper, certificates of deposit and government
securities. They offered bank-like services like transaction accounts and cheque-writing facilities
without bank regulation or deposit insurance backing.
Repos - Short-term loans whereby one party agrees to sell assets to another and buy them
back at a future date. Repos are commonly used by shadow banks to fund longer-term assets
through maturity transformation. The repo market grew enormously in the 2000s.
Commercial Paper (CP) - Short-term unsecured promissory notes issued by corporations to
fund expenses like payroll. CP issued by shadow banks was used interchangeably with MMMFs
as short-term funding sources.
Structured Investment Vehicles (SIVs) - Off-balance sheet entities that funded long-term assets
through the issuance of asset-backed CP. They relied on constant rollover of short-term
liabilities to finance assets.
Financial Guarantors - Monocline insurers who provided credit protection on mortgage-backed
securities, CDOs and CP through financial guarantees without adequate capital and modeling of
systemic risks.
Development and Scale of Shadow Banking
Shadow banking grew significantly in the pre-crisis period for a variety of reasons:
1. Regulatory Arbitrage - More stringent bank regulations from Basel I/II and minimum capital
requirements made unregulated entities more appealing. Shadow banking could intermediate
credit without holding regulatory capital.
2. Financial Innovation - New structured products enabled profitable transformation between
short-term funding/investing activities and long-term lending activities. This allowed greater
multiplication of leverage.
3. Securitization Boom - Driven by real estate bubbles, rapidly rising volumes of mortgage and
consumer debt securitization flooded global markets with AAA-rated structured products.
4. Low Interest Rates - After the 2001 US recession, sustained low rates boosted speculative
investments into high-yielding securitized assets and fueled leverage in the banking system.
By 2007, total US shadow banking liabilities were roughly equal to those of the traditional
banking sector at over $20 trillion each according to US Federal Reserve estimates. In Europe,
shadow banking assets held by institutions outside the banking system grew to around 50% of
Euro area GDP (FSB, 2012). Growth was even larger in emerging markets like China, Korea
and Mexico where shadow banking may have exceeded 100% of GDP (Ernst & Young, 2012).
This illustrated how it had become an enormous parallel banking system interconnected with
regulated banks globally.
Implications of Shadow Banking for Financial Stability
While shadow banking provided an important sources of funding liquidity and credit extension
during the pre-crisis period, its scale and interconnectedness with traditional banks highlighted
vulnerabilities that became apparent during the financial turmoil:
Procyclical Leverage - Shadow banks had largely unregulated leverage through repos, CP
issuance, ABCP conduits and off-balance sheet SIVs/CDOs. This amplified the economic cycle
by providing an abundance of credit during booms but exposed the system to deleveraging
during downturns.
Runs and Liquidity Spirals - Reliance on short-term wholesale funding left the entities highly
vulnerable to runs, as evidenced by investors rapidly withdrawing from MMMFs, repo and ABCP
markets in 2008. This created a liquidity crisis that spread to traditional banks.
Interconnectedness - Shadow banking entities were major counterparties and investors of
banks through repo lending, asset purchases and credit guarantees. When runs occurred in the
shadow system, losses spilled back onto regulated banks.
Toxic Asset Fire Sales - Forced liquidations of assets of defaulting shadow banks flooded
markets, depressed prices of securitized products, wiped out capital of monolines, and further
aggravated deleveraging and negative price spirals.
Procyclical Regulations - Banking regulations encouraged the migration of lending activities
outside of regulated institutions during the boom, only to see these non-bank intermediaries
collapse and reinforce the financial crisis. This exposed regulatory gaps and flaws in the
regulatory framework.
Opaqueness - Activities in repo, ABCP and securitization markets took place through complex
transactions without standardized disclosure requirements. This hampered monitoring,
prevented accurate risk measurement, and reduced transparency overall.
Maturity mismatches and liquidity risk transformations were exacerbated on a larger scale than
previously seen due to the tremendous growth of shadow banking entities globally which relied
on constant rollover of funding to finance longer-term and often illiquid assets. When short-term
funding markets broke down in interbank and commercial paper markets, it triggered a broader
deleveraging cycle. This transmission exacerbated the financial crisis and exposed the buildup
of systemic risks within the shadow banking system.
Regulatory Reforms
In the aftermath of the crisis, policymakers recognised the importance of addressing
vulnerabilities related to shadow banking activities. A range of reforms have since been agreed
to at the international and national levels aimed at tackling the regulatory arbitrage and closing
gaps exposed by the crisis. These include:
Stricter Regulation of MMMFs - The US introduced regulations like minimum liquidity buffers
and floating net asset values to reduce susceptibility to runs. Europe subjected MMMFs to
authorisation and supervision as alternative investment funds.
Regulation of Repo and Securities Financing Markets - International standards monitor haircuts
and re-hypothecation of collateral in repos. Minimum haircuts apply to low quality collateral.
Jurisdictions now regulate systemic repo entities.
Expanded Oversight of Non-Bank Intermediaries - Authorities in major jurisdictions now monitor
entities performing bank-like functions involving maturity/liquidity transformation. They may face
prudential standards and supervision commensurate with risks.
Enhanced Securitisation Standards - New rules mandate risk retention for originators of
securitised products to align interests. Standardised disclosure frameworks improve
transparency of securitisation vehicles.
Resolution Frameworks for Non-Banks - Authorities developed tools to wind-down non-bank
financial institutions in an orderly manner without destabilising the system, including bail-in
powers as needed.
Central Clearing of Derivatives - Mandatory central clearing of standard bilateral OTC
derivatives aimed to reduce counterparty risk and improve transparency of these markets, many
of which involved shadow banking players.
Liquidity Requirements - Basel III introduced standards like Liquidity Coverage Ratios and Net
Stable Funding Ratios to strengthen liquidity risk management at banks and limit maturity
mismatches. This aims to reduce procyclical reliance on volatile short-term wholesale funding.
Macroprudential Policies - Tools like countercyclical capital buffers and provisioning measures
aim to constrain excessive credit and leverage across the financial system including shadow
banks to reduce system-wide risks building during upswings.
Increased Data Collection and Monitoring - National regulators and international bodies collect
standardized data and conduct quantitative assessments of non-banks engaging in credit
intermediation to better understand exposures, connections and risks.
While reforms have made progress in reducing specific vulnerabilities, it remains challenging to
comprehensively regulate borderless shadow banking activities due to ongoing innovation.
Jurisdictions must cooperate globally on consistent implementation and close further arbitrage
opportunities to fully address buildup of potential systemic risk in non-bank finance. Active
monitoring is also required given shadow banking entities may evolve or migrate to unregulated
jurisdictions. Ongoing reforms are still needed to ensure appropriate oversight, transparency
and stabilisation policies extend to all areas of credit intermediation outside the traditional
banking system.
Conclusion
Shadow banking grew enormously in the decade preceding the global financial crisis as
financial innovation enabled large scale regulatory arbitrage and maturity/liquidity transformation
outside regulated institutions. By conducting core banking activities without oversight or
safeguards, it created unintended vulnerabilities in the broader financial system through
procyclical leverage, interconnectedness with regulated banks, and susceptibility to runs in short
term funding markets.
When the crisis erupted, it exposed the accumulation of neglected systemic risks within shadow
banking linkages. This amplified the severity of the crisis through fire sales of assets and
impaired liquidity in credit markets. Policymakers globally have since worked to identify these
oversights and implement reforms addressing the core weaknesses around opacity, unstable
wholesale funding, leverage, securitisation, liquidity mismatches and inconsistent regulation
brought to light.
While standards continue to evolve, full oversight of borderless and innovative shadow banking
remains a long term challenge requiring vigilance and cooperation. Constant monitoring of new
forms of regulatory arbitrage and macroprudential policies are needed to control excessive
risk-taking outside the regular banking system on both a micro and macro level. Ongoing
sustainable reform would help prevent future turbulence from building again within regulated
and unregulated sectors of the financial system alike. With proper regulations and oversight in
place, shadow banking could potentially be better harnessed to provide stable market-based
finance for the economy.
The global financial crisis starting in 2007 revealed vulnerabilities in key parts of the financial
system that were previously overlooked or not well understood. One such area was the
development of ‘shadow banking’ – complex financial intermediation conducted through
institutions and mechanisms outside of traditional banking regulation. This essay will explore the
concept and key components of shadow banking, how it developed and how large it has
become. It will then assess the implications shadow banking poses for overall financial stability
through its interconnections with traditional banks and impact on maturity and liquidity
transformation. The essay will conclude by considering regulatory reforms aimed at addressing
the regulatory arbitrage and systemic risk created by shadow banking.
Defining Shadow Banking
There is no universally agreed definition of shadow banking, as the term encompasses a
diverse set of activities, institutions and entities. In general terms, shadow banking refers to
credit intermediation that takes place outside of the traditional banking system through various
unregulated and non-bank financial intermediaries. This includes entities conducting activities
like securitization, collateralized lending, money market mutual funds and repos. A useful
definition comes from the Financial Stability Board (FSB), who define shadow banking as “credit
intermediation involving entities and activities outside the regular banking system” (FSB, 2011).
Three key characteristics are commonly attributed to shadow banking activities according to the
FSB:
1. Maturity transformation - Many shadow banking entities fund longer-term assets with
short-term liabilities through repo markets, commercial paper or money market funds. This
exposes them to runs by liability holders.
2. Leverage - Shadow banking intermediaries typically use high degrees of financial and/or
economic leverage to generate greater returns.
3. Liquidity transformation - They collect demand deposits or other short-term liabilities from
investors that can be redeemed quickly even though their assets cannot be quickly sold or are
illiquid.
Key Shadow Banking Components
A number of specific entities and activities have developed within the shadow banking system
through various regulatory arbitrage opportunities. Among the main components are:
Securitization - The process of pooling together various types of financial assets like mortgages,
auto loans or credit cards into financial instruments which are then sold to investors. This
allowed non-bank entities to intermediate credit and transfer risk away from originating banks.
Securitization vehicles largely sat outside the regulated banking system and grew rapidly
leading up to the crisis.
Money Market Mutual Funds (MMMFs) - Open-ended mutual funds that invest primarily in
short-term, low risk instruments like commercial paper, certificates of deposit and government
securities. They offered bank-like services like transaction accounts and cheque-writing facilities
without bank regulation or deposit insurance backing.
Repos - Short-term loans whereby one party agrees to sell assets to another and buy them
back at a future date. Repos are commonly used by shadow banks to fund longer-term assets
through maturity transformation. The repo market grew enormously in the 2000s.
Commercial Paper (CP) - Short-term unsecured promissory notes issued by corporations to
fund expenses like payroll. CP issued by shadow banks was used interchangeably with MMMFs
as short-term funding sources.
Structured Investment Vehicles (SIVs) - Off-balance sheet entities that funded long-term assets
through the issuance of asset-backed CP. They relied on constant rollover of short-term
liabilities to finance assets.
Financial Guarantors - Monocline insurers who provided credit protection on mortgage-backed
securities, CDOs and CP through financial guarantees without adequate capital and modeling of
systemic risks.
Development and Scale of Shadow Banking
Shadow banking grew significantly in the pre-crisis period for a variety of reasons:
1. Regulatory Arbitrage - More stringent bank regulations from Basel I/II and minimum capital
requirements made unregulated entities more appealing. Shadow banking could intermediate
credit without holding regulatory capital.
2. Financial Innovation - New structured products enabled profitable transformation between
short-term funding/investing activities and long-term lending activities. This allowed greater
multiplication of leverage.
3. Securitization Boom - Driven by real estate bubbles, rapidly rising volumes of mortgage and
consumer debt securitization flooded global markets with AAA-rated structured products.
4. Low Interest Rates - After the 2001 US recession, sustained low rates boosted speculative
investments into high-yielding securitized assets and fueled leverage in the banking system.
By 2007, total US shadow banking liabilities were roughly equal to those of the traditional
banking sector at over $20 trillion each according to US Federal Reserve estimates. In Europe,
shadow banking assets held by institutions outside the banking system grew to around 50% of
Euro area GDP (FSB, 2012). Growth was even larger in emerging markets like China, Korea
and Mexico where shadow banking may have exceeded 100% of GDP (Ernst & Young, 2012).
This illustrated how it had become an enormous parallel banking system interconnected with
regulated banks globally.
Implications of Shadow Banking for Financial Stability
While shadow banking provided an important sources of funding liquidity and credit extension
during the pre-crisis period, its scale and interconnectedness with traditional banks highlighted
vulnerabilities that became apparent during the financial turmoil:
Procyclical Leverage - Shadow banks had largely unregulated leverage through repos, CP
issuance, ABCP conduits and off-balance sheet SIVs/CDOs. This amplified the economic cycle
by providing an abundance of credit during booms but exposed the system to deleveraging
during downturns.
Runs and Liquidity Spirals - Reliance on short-term wholesale funding left the entities highly
vulnerable to runs, as evidenced by investors rapidly withdrawing from MMMFs, repo and ABCP
markets in 2008. This created a liquidity crisis that spread to traditional banks.
Interconnectedness - Shadow banking entities were major counterparties and investors of
banks through repo lending, asset purchases and credit guarantees. When runs occurred in the
shadow system, losses spilled back onto regulated banks.
Toxic Asset Fire Sales - Forced liquidations of assets of defaulting shadow banks flooded
markets, depressed prices of securitized products, wiped out capital of monolines, and further
aggravated deleveraging and negative price spirals.
Procyclical Regulations - Banking regulations encouraged the migration of lending activities
outside of regulated institutions during the boom, only to see these non-bank intermediaries
collapse and reinforce the financial crisis. This exposed regulatory gaps and flaws in the
regulatory framework.
Opaqueness - Activities in repo, ABCP and securitization markets took place through complex
transactions without standardized disclosure requirements. This hampered monitoring,
prevented accurate risk measurement, and reduced transparency overall.
Maturity mismatches and liquidity risk transformations were exacerbated on a larger scale than
previously seen due to the tremendous growth of shadow banking entities globally which relied
on constant rollover of funding to finance longer-term and often illiquid assets. When short-term
funding markets broke down in interbank and commercial paper markets, it triggered a broader
deleveraging cycle. This transmission exacerbated the financial crisis and exposed the buildup
of systemic risks within the shadow banking system.
Regulatory Reforms
In the aftermath of the crisis, policymakers recognised the importance of addressing
vulnerabilities related to shadow banking activities. A range of reforms have since been agreed
to at the international and national levels aimed at tackling the regulatory arbitrage and closing
gaps exposed by the crisis. These include:
Stricter Regulation of MMMFs - The US introduced regulations like minimum liquidity buffers
and floating net asset values to reduce susceptibility to runs. Europe subjected MMMFs to
authorisation and supervision as alternative investment funds.
Regulation of Repo and Securities Financing Markets - International standards monitor haircuts
and re-hypothecation of collateral in repos. Minimum haircuts apply to low quality collateral.
Jurisdictions now regulate systemic repo entities.
Expanded Oversight of Non-Bank Intermediaries - Authorities in major jurisdictions now monitor
entities performing bank-like functions involving maturity/liquidity transformation. They may face
prudential standards and supervision commensurate with risks.
Enhanced Securitisation Standards - New rules mandate risk retention for originators of
securitised products to align interests. Standardised disclosure frameworks improve
transparency of securitisation vehicles.
Resolution Frameworks for Non-Banks - Authorities developed tools to wind-down non-bank
financial institutions in an orderly manner without destabilising the system, including bail-in
powers as needed.
Central Clearing of Derivatives - Mandatory central clearing of standard bilateral OTC
derivatives aimed to reduce counterparty risk and improve transparency of these markets, many
of which involved shadow banking players.
Liquidity Requirements - Basel III introduced standards like Liquidity Coverage Ratios and Net
Stable Funding Ratios to strengthen liquidity risk management at banks and limit maturity
mismatches. This aims to reduce procyclical reliance on volatile short-term wholesale funding.
Macroprudential Policies - Tools like countercyclical capital buffers and provisioning measures
aim to constrain excessive credit and leverage across the financial system including shadow
banks to reduce system-wide risks building during upswings.
Increased Data Collection and Monitoring - National regulators and international bodies collect
standardized data and conduct quantitative assessments of non-banks engaging in credit
intermediation to better understand exposures, connections and risks.
While reforms have made progress in reducing specific vulnerabilities, it remains challenging to
comprehensively regulate borderless shadow banking activities due to ongoing innovation.
Jurisdictions must cooperate globally on consistent implementation and close further arbitrage
opportunities to fully address buildup of potential systemic risk in non-bank finance. Active
monitoring is also required given shadow banking entities may evolve or migrate to unregulated
jurisdictions. Ongoing reforms are still needed to ensure appropriate oversight, transparency
and stabilisation policies extend to all areas of credit intermediation outside the traditional
banking system.
Conclusion
Shadow banking grew enormously in the decade preceding the global financial crisis as
financial innovation enabled large scale regulatory arbitrage and maturity/liquidity transformation
outside regulated institutions. By conducting core banking activities without oversight or
safeguards, it created unintended vulnerabilities in the broader financial system through
procyclical leverage, interconnectedness with regulated banks, and susceptibility to runs in short
term funding markets.
When the crisis erupted, it exposed the accumulation of neglected systemic risks within shadow
banking linkages. This amplified the severity of the crisis through fire sales of assets and
impaired liquidity in credit markets. Policymakers globally have since worked to identify these
oversights and implement reforms addressing the core weaknesses around opacity, unstable
wholesale funding, leverage, securitisation, liquidity mismatches and inconsistent regulation
brought to light.
While standards continue to evolve, full oversight of borderless and innovative shadow banking
remains a long term challenge requiring vigilance and cooperation. Constant monitoring of new
forms of regulatory arbitrage and macroprudential policies are needed to control excessive
risk-taking outside the regular banking system on both a micro and macro level. Ongoing
sustainable reform would help prevent future turbulence from building again within regulated
and unregulated sectors of the financial system alike. With proper regulations and oversight in
place, shadow banking could potentially be better harnessed to provide stable market-based
finance for the economy.
The global financial crisis starting in 2007 revealed vulnerabilities in key parts of the financial
system that were previously overlooked or not well understood. One such area was the
development of ‘shadow banking’ – complex financial intermediation conducted through
institutions and mechanisms outside of traditional banking regulation. This essay will explore the
concept and key components of shadow banking, how it developed and how large it has
become. It will then assess the implications shadow banking poses for overall financial stability
through its interconnections with traditional banks and impact on maturity and liquidity
transformation. The essay will conclude by considering regulatory reforms aimed at addressing
the regulatory arbitrage and systemic risk created by shadow banking.
Defining Shadow Banking
There is no universally agreed definition of shadow banking, as the term encompasses a
diverse set of activities, institutions and entities. In general terms, shadow banking refers to
credit intermediation that takes place outside of the traditional banking system through various
unregulated and non-bank financial intermediaries. This includes entities conducting activities
like securitization, collateralized lending, money market mutual funds and repos. A useful
definition comes from the Financial Stability Board (FSB), who define shadow banking as “credit
intermediation involving entities and activities outside the regular banking system” (FSB, 2011).
Three key characteristics are commonly attributed to shadow banking activities according to the
FSB:
1. Maturity transformation - Many shadow banking entities fund longer-term assets with
short-term liabilities through repo markets, commercial paper or money market funds. This
exposes them to runs by liability holders.
2. Leverage - Shadow banking intermediaries typically use high degrees of financial and/or
economic leverage to generate greater returns.
3. Liquidity transformation - They collect demand deposits or other short-term liabilities from
investors that can be redeemed quickly even though their assets cannot be quickly sold or are
illiquid.
Key Shadow Banking Components
A number of specific entities and activities have developed within the shadow banking system
through various regulatory arbitrage opportunities. Among the main components are:
Securitization - The process of pooling together various types of financial assets like mortgages,
auto loans or credit cards into financial instruments which are then sold to investors. This
allowed non-bank entities to intermediate credit and transfer risk away from originating banks.
Securitization vehicles largely sat outside the regulated banking system and grew rapidly
leading up to the crisis.
Money Market Mutual Funds (MMMFs) - Open-ended mutual funds that invest primarily in
short-term, low risk instruments like commercial paper, certificates of deposit and government
securities. They offered bank-like services like transaction accounts and cheque-writing facilities
without bank regulation or deposit insurance backing.
Repos - Short-term loans whereby one party agrees to sell assets to another and buy them
back at a future date. Repos are commonly used by shadow banks to fund longer-term assets
through maturity transformation. The repo market grew enormously in the 2000s.
Commercial Paper (CP) - Short-term unsecured promissory notes issued by corporations to
fund expenses like payroll. CP issued by shadow banks was used interchangeably with MMMFs
as short-term funding sources.
Structured Investment Vehicles (SIVs) - Off-balance sheet entities that funded long-term assets
through the issuance of asset-backed CP. They relied on constant rollover of short-term
liabilities to finance assets.
Financial Guarantors - Monocline insurers who provided credit protection on mortgage-backed
securities, CDOs and CP through financial guarantees without adequate capital and modeling of
systemic risks.
Development and Scale of Shadow Banking
Shadow banking grew significantly in the pre-crisis period for a variety of reasons:
1. Regulatory Arbitrage - More stringent bank regulations from Basel I/II and minimum capital
requirements made unregulated entities more appealing. Shadow banking could intermediate
credit without holding regulatory capital.
2. Financial Innovation - New structured products enabled profitable transformation between
short-term funding/investing activities and long-term lending activities. This allowed greater
multiplication of leverage.
3. Securitization Boom - Driven by real estate bubbles, rapidly rising volumes of mortgage and
consumer debt securitization flooded global markets with AAA-rated structured products.
4. Low Interest Rates - After the 2001 US recession, sustained low rates boosted speculative
investments into high-yielding securitized assets and fueled leverage in the banking system.
By 2007, total US shadow banking liabilities were roughly equal to those of the traditional
banking sector at over $20 trillion each according to US Federal Reserve estimates. In Europe,
shadow banking assets held by institutions outside the banking system grew to around 50% of
Euro area GDP (FSB, 2012). Growth was even larger in emerging markets like China, Korea
and Mexico where shadow banking may have exceeded 100% of GDP (Ernst & Young, 2012).
This illustrated how it had become an enormous parallel banking system interconnected with
regulated banks globally.
Implications of Shadow Banking for Financial Stability
While shadow banking provided an important sources of funding liquidity and credit extension
during the pre-crisis period, its scale and interconnectedness with traditional banks highlighted
vulnerabilities that became apparent during the financial turmoil:
Procyclical Leverage - Shadow banks had largely unregulated leverage through repos, CP
issuance, ABCP conduits and off-balance sheet SIVs/CDOs. This amplified the economic cycle
by providing an abundance of credit during booms but exposed the system to deleveraging
during downturns.
Runs and Liquidity Spirals - Reliance on short-term wholesale funding left the entities highly
vulnerable to runs, as evidenced by investors rapidly withdrawing from MMMFs, repo and ABCP
markets in 2008. This created a liquidity crisis that spread to traditional banks.
Interconnectedness - Shadow banking entities were major counterparties and investors of
banks through repo lending, asset purchases and credit guarantees. When runs occurred in the
shadow system, losses spilled back onto regulated banks.
Toxic Asset Fire Sales - Forced liquidations of assets of defaulting shadow banks flooded
markets, depressed prices of securitized products, wiped out capital of monolines, and further
aggravated deleveraging and negative price spirals.
Procyclical Regulations - Banking regulations encouraged the migration of lending activities
outside of regulated institutions during the boom, only to see these non-bank intermediaries
collapse and reinforce the financial crisis. This exposed regulatory gaps and flaws in the
regulatory framework.
Opaqueness - Activities in repo, ABCP and securitization markets took place through complex
transactions without standardized disclosure requirements. This hampered monitoring,
prevented accurate risk measurement, and reduced transparency overall.
Maturity mismatches and liquidity risk transformations were exacerbated on a larger scale than
previously seen due to the tremendous growth of shadow banking entities globally which relied
on constant rollover of funding to finance longer-term and often illiquid assets. When short-term
funding markets broke down in interbank and commercial paper markets, it triggered a broader
deleveraging cycle. This transmission exacerbated the financial crisis and exposed the buildup
of systemic risks within the shadow banking system.
Regulatory Reforms
In the aftermath of the crisis, policymakers recognised the importance of addressing
vulnerabilities related to shadow banking activities. A range of reforms have since been agreed
to at the international and national levels aimed at tackling the regulatory arbitrage and closing
gaps exposed by the crisis. These include:
Stricter Regulation of MMMFs - The US introduced regulations like minimum liquidity buffers
and floating net asset values to reduce susceptibility to runs. Europe subjected MMMFs to
authorisation and supervision as alternative investment funds.
Regulation of Repo and Securities Financing Markets - International standards monitor haircuts
and re-hypothecation of collateral in repos. Minimum haircuts apply to low quality collateral.
Jurisdictions now regulate systemic repo entities.
Expanded Oversight of Non-Bank Intermediaries - Authorities in major jurisdictions now monitor
entities performing bank-like functions involving maturity/liquidity transformation. They may face
prudential standards and supervision commensurate with risks.
Enhanced Securitisation Standards - New rules mandate risk retention for originators of
securitised products to align interests. Standardised disclosure frameworks improve
transparency of securitisation vehicles.
Resolution Frameworks for Non-Banks - Authorities developed tools to wind-down non-bank
financial institutions in an orderly manner without destabilising the system, including bail-in
powers as needed.
Central Clearing of Derivatives - Mandatory central clearing of standard bilateral OTC
derivatives aimed to reduce counterparty risk and improve transparency of these markets, many
of which involved shadow banking players.
Liquidity Requirements - Basel III introduced standards like Liquidity Coverage Ratios and Net
Stable Funding Ratios to strengthen liquidity risk management at banks and limit maturity
mismatches. This aims to reduce procyclical reliance on volatile short-term wholesale funding.
Macroprudential Policies - Tools like countercyclical capital buffers and provisioning measures
aim to constrain excessive credit and leverage across the financial system including shadow
banks to reduce system-wide risks building during upswings.
Increased Data Collection and Monitoring - National regulators and international bodies collect
standardized data and conduct quantitative assessments of non-banks engaging in credit
intermediation to better understand exposures, connections and risks.
While reforms have made progress in reducing specific vulnerabilities, it remains challenging to
comprehensively regulate borderless shadow banking activities due to ongoing innovation.
Jurisdictions must cooperate globally on consistent implementation and close further arbitrage
opportunities to fully address buildup of potential systemic risk in non-bank finance. Active
monitoring is also required given shadow banking entities may evolve or migrate to unregulated
jurisdictions. Ongoing reforms are still needed to ensure appropriate oversight, transparency
and stabilisation policies extend to all areas of credit intermediation outside the traditional
banking system.
Conclusion
Shadow banking grew enormously in the decade preceding the global financial crisis as
financial innovation enabled large scale regulatory arbitrage and maturity/liquidity transformation
outside regulated institutions. By conducting core banking activities without oversight or
safeguards, it created unintended vulnerabilities in the broader financial system through
procyclical leverage, interconnectedness with regulated banks, and susceptibility to runs in short
term funding markets.
When the crisis erupted, it exposed the accumulation of neglected systemic risks within shadow
banking linkages. This amplified the severity of the crisis through fire sales of assets and
impaired liquidity in credit markets. Policymakers globally have since worked to identify these
oversights and implement reforms addressing the core weaknesses around opacity, unstable
wholesale funding, leverage, securitisation, liquidity mismatches and inconsistent regulation
brought to light.
While standards continue to evolve, full oversight of borderless and innovative shadow banking
remains a long term challenge requiring vigilance and cooperation. Constant monitoring of new
forms of regulatory arbitrage and macroprudential policies are needed to control excessive
risk-taking outside the regular banking system on both a micro and macro level. Ongoing
sustainable reform would help prevent future turbulence from building again within regulated
and unregulated sectors of the financial system alike. With proper regulations and oversight in
place, shadow banking could potentially be better harnessed to provide stable market-based
finance for the economy.
The global financial crisis starting in 2007 revealed vulnerabilities in key parts of the financial
system that were previously overlooked or not well understood. One such area was the
development of ‘shadow banking’ – complex financial intermediation conducted through
institutions and mechanisms outside of traditional banking regulation. This essay will explore the
concept and key components of shadow banking, how it developed and how large it has
become. It will then assess the implications shadow banking poses for overall financial stability
through its interconnections with traditional banks and impact on maturity and liquidity
transformation. The essay will conclude by considering regulatory reforms aimed at addressing
the regulatory arbitrage and systemic risk created by shadow banking.
Defining Shadow Banking
There is no universally agreed definition of shadow banking, as the term encompasses a
diverse set of activities, institutions and entities. In general terms, shadow banking refers to
credit intermediation that takes place outside of the traditional banking system through various
unregulated and non-bank financial intermediaries. This includes entities conducting activities
like securitization, collateralized lending, money market mutual funds and repos. A useful
definition comes from the Financial Stability Board (FSB), who define shadow banking as “credit
intermediation involving entities and activities outside the regular banking system” (FSB, 2011).
Three key characteristics are commonly attributed to shadow banking activities according to the
FSB:
1. Maturity transformation - Many shadow banking entities fund longer-term assets with
short-term liabilities through repo markets, commercial paper or money market funds. This
exposes them to runs by liability holders.
2. Leverage - Shadow banking intermediaries typically use high degrees of financial and/or
economic leverage to generate greater returns.
3. Liquidity transformation - They collect demand deposits or other short-term liabilities from
investors that can be redeemed quickly even though their assets cannot be quickly sold or are
illiquid.
Key Shadow Banking Components
A number of specific entities and activities have developed within the shadow banking system
through various regulatory arbitrage opportunities. Among the main components are:
Securitization - The process of pooling together various types of financial assets like mortgages,
auto loans or credit cards into financial instruments which are then sold to investors. This
allowed non-bank entities to intermediate credit and transfer risk away from originating banks.
Securitization vehicles largely sat outside the regulated banking system and grew rapidly
leading up to the crisis.
Money Market Mutual Funds (MMMFs) - Open-ended mutual funds that invest primarily in
short-term, low risk instruments like commercial paper, certificates of deposit and government
securities. They offered bank-like services like transaction accounts and cheque-writing facilities
without bank regulation or deposit insurance backing.
Repos - Short-term loans whereby one party agrees to sell assets to another and buy them
back at a future date. Repos are commonly used by shadow banks to fund longer-term assets
through maturity transformation. The repo market grew enormously in the 2000s.
Commercial Paper (CP) - Short-term unsecured promissory notes issued by corporations to
fund expenses like payroll. CP issued by shadow banks was used interchangeably with MMMFs
as short-term funding sources.
Structured Investment Vehicles (SIVs) - Off-balance sheet entities that funded long-term assets
through the issuance of asset-backed CP. They relied on constant rollover of short-term
liabilities to finance assets.
Financial Guarantors - Monocline insurers who provided credit protection on mortgage-backed
securities, CDOs and CP through financial guarantees without adequate capital and modeling of
systemic risks.
Development and Scale of Shadow Banking
Shadow banking grew significantly in the pre-crisis period for a variety of reasons:
1. Regulatory Arbitrage - More stringent bank regulations from Basel I/II and minimum capital
requirements made unregulated entities more appealing. Shadow banking could intermediate
credit without holding regulatory capital.
2. Financial Innovation - New structured products enabled profitable transformation between
short-term funding/investing activities and long-term lending activities. This allowed greater
multiplication of leverage.
3. Securitization Boom - Driven by real estate bubbles, rapidly rising volumes of mortgage and
consumer debt securitization flooded global markets with AAA-rated structured products.
4. Low Interest Rates - After the 2001 US recession, sustained low rates boosted speculative
investments into high-yielding securitized assets and fueled leverage in the banking system.
By 2007, total US shadow banking liabilities were roughly equal to those of the traditional
banking sector at over $20 trillion each according to US Federal Reserve estimates. In Europe,
shadow banking assets held by institutions outside the banking system grew to around 50% of
Euro area GDP (FSB, 2012). Growth was even larger in emerging markets like China, Korea
and Mexico where shadow banking may have exceeded 100% of GDP (Ernst & Young, 2012).
This illustrated how it had become an enormous parallel banking system interconnected with
regulated banks globally.
Implications of Shadow Banking for Financial Stability
While shadow banking provided an important sources of funding liquidity and credit extension
during the pre-crisis period, its scale and interconnectedness with traditional banks highlighted
vulnerabilities that became apparent during the financial turmoil:
Procyclical Leverage - Shadow banks had largely unregulated leverage through repos, CP
issuance, ABCP conduits and off-balance sheet SIVs/CDOs. This amplified the economic cycle
by providing an abundance of credit during booms but exposed the system to deleveraging
during downturns.
Runs and Liquidity Spirals - Reliance on short-term wholesale funding left the entities highly
vulnerable to runs, as evidenced by investors rapidly withdrawing from MMMFs, repo and ABCP
markets in 2008. This created a liquidity crisis that spread to traditional banks.
Interconnectedness - Shadow banking entities were major counterparties and investors of
banks through repo lending, asset purchases and credit guarantees. When runs occurred in the
shadow system, losses spilled back onto regulated banks.
Toxic Asset Fire Sales - Forced liquidations of assets of defaulting shadow banks flooded
markets, depressed prices of securitized products, wiped out capital of monolines, and further
aggravated deleveraging and negative price spirals.
Procyclical Regulations - Banking regulations encouraged the migration of lending activities
outside of regulated institutions during the boom, only to see these non-bank intermediaries
collapse and reinforce the financial crisis. This exposed regulatory gaps and flaws in the
regulatory framework.
Opaqueness - Activities in repo, ABCP and securitization markets took place through complex
transactions without standardized disclosure requirements. This hampered monitoring,
prevented accurate risk measurement, and reduced transparency overall.
Maturity mismatches and liquidity risk transformations were exacerbated on a larger scale than
previously seen due to the tremendous growth of shadow banking entities globally which relied
on constant rollover of funding to finance longer-term and often illiquid assets. When short-term
funding markets broke down in interbank and commercial paper markets, it triggered a broader
deleveraging cycle. This transmission exacerbated the financial crisis and exposed the buildup
of systemic risks within the shadow banking system.
Regulatory Reforms
In the aftermath of the crisis, policymakers recognised the importance of addressing
vulnerabilities related to shadow banking activities. A range of reforms have since been agreed
to at the international and national levels aimed at tackling the regulatory arbitrage and closing
gaps exposed by the crisis. These include:
Stricter Regulation of MMMFs - The US introduced regulations like minimum liquidity buffers
and floating net asset values to reduce susceptibility to runs. Europe subjected MMMFs to
authorisation and supervision as alternative investment funds.
Regulation of Repo and Securities Financing Markets - International standards monitor haircuts
and re-hypothecation of collateral in repos. Minimum haircuts apply to low quality collateral.
Jurisdictions now regulate systemic repo entities.
Expanded Oversight of Non-Bank Intermediaries - Authorities in major jurisdictions now monitor
entities performing bank-like functions involving maturity/liquidity transformation. They may face
prudential standards and supervision commensurate with risks.
Enhanced Securitisation Standards - New rules mandate risk retention for originators of
securitised products to align interests. Standardised disclosure frameworks improve
transparency of securitisation vehicles.
Resolution Frameworks for Non-Banks - Authorities developed tools to wind-down non-bank
financial institutions in an orderly manner without destabilising the system, including bail-in
powers as needed.
Central Clearing of Derivatives - Mandatory central clearing of standard bilateral OTC
derivatives aimed to reduce counterparty risk and improve transparency of these markets, many
of which involved shadow banking players.
Liquidity Requirements - Basel III introduced standards like Liquidity Coverage Ratios and Net
Stable Funding Ratios to strengthen liquidity risk management at banks and limit maturity
mismatches. This aims to reduce procyclical reliance on volatile short-term wholesale funding.
Macroprudential Policies - Tools like countercyclical capital buffers and provisioning measures
aim to constrain excessive credit and leverage across the financial system including shadow
banks to reduce system-wide risks building during upswings.
Increased Data Collection and Monitoring - National regulators and international bodies collect
standardized data and conduct quantitative assessments of non-banks engaging in credit
intermediation to better understand exposures, connections and risks.
While reforms have made progress in reducing specific vulnerabilities, it remains challenging to
comprehensively regulate borderless shadow banking activities due to ongoing innovation.
Jurisdictions must cooperate globally on consistent implementation and close further arbitrage
opportunities to fully address buildup of potential systemic risk in non-bank finance. Active
monitoring is also required given shadow banking entities may evolve or migrate to unregulated
jurisdictions. Ongoing reforms are still needed to ensure appropriate oversight, transparency
and stabilisation policies extend to all areas of credit intermediation outside the traditional
banking system.
Conclusion
Shadow banking grew enormously in the decade preceding the global financial crisis as
financial innovation enabled large scale regulatory arbitrage and maturity/liquidity transformation
outside regulated institutions. By conducting core banking activities without oversight or
safeguards, it created unintended vulnerabilities in the broader financial system through
procyclical leverage, interconnectedness with regulated banks, and susceptibility to runs in short
term funding markets.
When the crisis erupted, it exposed the accumulation of neglected systemic risks within shadow
banking linkages. This amplified the severity of the crisis through fire sales of assets and
impaired liquidity in credit markets. Policymakers globally have since worked to identify these
oversights and implement reforms addressing the core weaknesses around opacity, unstable
wholesale funding, leverage, securitisation, liquidity mismatches and inconsistent regulation
brought to light.
While standards continue to evolve, full oversight of borderless and innovative shadow banking
remains a long term challenge requiring vigilance and cooperation. Constant monitoring of new
forms of regulatory arbitrage and macroprudential policies are needed to control excessive
risk-taking outside the regular banking system on both a micro and macro level. Ongoing
sustainable reform would help prevent future turbulence from building again within regulated
and unregulated sectors of the financial system alike. With proper regulations and oversight in
place, shadow banking could potentially be better harnessed to provide stable market-based
finance for the economy.
