Shadow banks represent nearly 25% of the financial industry, but many are unsure of their actual role in the industry. Shadow banks are large financial players who are not regulated like banks, things like hedge funds and Structured Investment Vehicles sponsored by banks. Such entities typically operate in a highly leveraged manner, amping up risk to increase profits. The greatest threat posed by such entities was not necessarily the risk they undertake but the lack of transparency they offer, both to regulators and counterparties.

Q. So we all have some idea about Shadow Banks, but the term sure sound very mysterious! What are they, exactly?
Financial players whose behavior isn’t regulated like banks are: hedge funds, and bank-sponsored SIVs (Strucutured Investment Vehicles) are two very important examples. Term is very popular now but only dates to 2007. Origin of these entities probably dates back to money market funds in the 70s, which attracted lots of $, and act like bank deposits but aren’t.

Q. So, just to review for a second, many folks believe these shadow banks were at the heart of the financial crisis. Why?
A. First, they were—and still are—a gigantic share of the financial industry, maybe 25% of it today, but maybe half of it at the peak. Second, these firms often operate in a highly leveraged way that can be extremely profitable, but also extremely risky: borrow short (through CP and repos, for example) and lend long (purchasing securitized products). Then, you also had groups like AIG, which are technically not part of the shadow banking system, but acted that way by issuing incredible volumes of CDS contracts (which weren’t considered insurance contracts).

Q. And so the big problem was that so much risky leverage was being created without the regulators having any visibility or control?
A. Yes, but not just the regulators: Counterparties didn’t know which entities were on the hook, and which banks—which sponsored many of these vehicles – would wind up being liable even though they were legally separate. Nobody knew where the losses really were, and therefore who could be a trusted counterparty. Ala, a credit freeze. That’s why, to me, transparency really more of an issue than regulation… markets deal well with known facts, but behave terribly in the face of big unknowns.

Q. And things like the new Rule PF are aimed at that, right?
A. Yes, large hedge funds just had to start filing something called a Form PF, which describes their strategies, holdings, leverage, etc. What we have to remember is that we can’t just shut down all non-bank lending activity: that’s really crucial to grow the economy and get housing going again. The trick is to do it through transparent vehicles, that do not effectively represent liabilities of regulated banks, that everyone can see and evaluate the risks. Non banks are good; but they need to be out of the shadows.