The role of shadow banking entities in the financial crisis: a disaggregated view

ABSTRACT

This article examines the role of the shadow banking system in the global financial crisis of 2007–9. In order to do this, one must first explain the reasons for the explosive growth of shadow banking in the immediate pre-crisis era. Current explanations for this growth tend to hold two contrasting positions: one emphasising factors endogenous to the banking sector (notably regulatory arbitrage and financial innovation); the other emphasising exogenous factors (notably the ‘search for yield’). Integrating these two explanations, in this article we develop a disaggregated view of the shadow banking system. After clarifying the nature of the relation between the regulated and shadow banking systems, we inquire more closely into the different entities that inhabit the shadow banking system, the different activities that these entities performed and the different financial products that these entities supplied. The disaggregated view of shadow banking suggests that while some parts of the system played an important role in the initial subprime phase of the crisis through their involvement with the toxic securities that were at its centre, other parts of the system were key to the subsequent money and inter-bank phases of the crisis through their close ties with the regulated banks.

KEYWORDS:

• shadow banking
• securitization
• financial crisis
• financial regulation

ACKNOWLEDGMENTS

The authors would like to thank Daniel Awrey and three anonymous referees for their comments on earlier drafts of this paper.

Notes

1. Bakk-Simon et al. (2012), writing under the auspices of the European Central Bank, follow the FSB's definition of the shadow banking system.

2. Gorton and Metrick (2010) have proposed that following the ‘run on the repo’, which in their view caused the financial crisis of 2007–8, there should be tighter restrictions on the creation and distribution of ABSs, the long-term securities that provided much of the collateral fodder for the short-term repo transactions. However, what their proposal ignores is the fact that a good deal of the ABSs created before the crisis were held by pension funds and other institutional investors and were not financed by short-term repos. To quote from Shleifer's critical comment on the Gorton-Metrick proposal: ‘at least some, and possibly a good part, of ABSs were acquired by pension funds, insurance companies, and even government sponsored enterprises. For these buyers, short term financing was probably much less important. The reason this observation is of some consequence is that Gorton and Metrick's regulatory proposal would require that ABSs be maturity transformed, which presumably would prevent their being sold to investors in long-term securities. I am far from certain that this would be desirable’ (Shleifer, 2010: 300).

Additional information

Notes on contributors

Photis Lysandrou

Professor Photis Lysandrou is a Research fellow at City Political Economy Research Centre (CITYPERC), London, UK. Until 2013 he was professor of Global Political Economy at London Metropolitan University. He has published widely on the issues of finance, inequality and financial crisis. He can be contacted at [email protected]

Anastasia Nesvetailova

Dr Anastasia Nesvetailova is a Reader in International Political Economy at City University London and Director of the City Political Economy Research Centre (CITYPERC). Her publications include Fragile Finance: Debt, Speculation and Crisis in the Age of Global Credit (2007, Palgrave) and Financial Alchemy in Crisis: The Great Liquidity Illusion (2010, Pluto). Her email address is: [email protected]