Shadow Banking

By: Dr. Lynn Reaser

This week the Federal Reserve Bank of Atlanta is hosting a seminar on bank regulatory issues, attended by policy officials, academics, and representatives of the private sector. Much of the focus is on the shadow banking sector and the risks that it may pose. A shadow bank is defined as an institution that performs credit or deposit functions outside of the regulatory confines of banks. Today, approximately 40% of credit creation in the United States is conducted through these shadow banks. These include institutions as diverse as money market mutual funds, hedge funds, and insurance companies

The Federal Reserve is determined that a financial crisis, such as took place in 2008, not be repeated. While it believes it has enough controls on banks, shadow banks could pose a bigger threat. The Fed is monitoring activities of those institutions closely. The government also has the power to declare an institution “systemically important” or in a position to threaten the overall financial stability of the economy. That designation then allows the Federal Reserve to exercise its various regulatory tools, such as increased capital or liquidity requirements.

Policy officials clearly no longer believe that the market will police the financial system to avoid the possibility of collapse. It is far from obvious that another financial crisis can be avoided, but the Federal Reserve is certainly deploying a “full court press” to avert its recurrence.


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