Shadow banking is back. A constellation of less-regulated intermediaries — from insurers to private investment funds — is increasingly taking on the traditional business of banks, making trillions of dollars in risky loans and occupying a central role in the economy.
Will this end badly, as it did in the 2008 financial crisis? Not necessarily — if authorities act to address the growing dangers.
Banking is an inherently fragile endeavor. By funding long-term investments with money they’ve promised to pay back at short notice, banks expose themselves to the risk that customers will demand their cash back all at once. Since such runs can cripple the economy, governments provide backstops (such as deposit insurance and central-bank loans) and impose regulations aimed at ensuring resilience.
Other financial institutions, however, persistently seek to replicate banking without the regulation. Much of the subprime-mortgage boom of the 2000s was funded with short-term borrowing by nonbanks, including money-market mutual funds, securities firms and insurers. When rising defaults triggered a run, officials had little choice but to bail these companies out.
This time around, shadow banking looks less precarious. The lending is vast and risky: Nonbanks have more than $2 trillion outstanding, often to smaller businesses with shaky credit. But the lenders — including private-credit funds, business-development companies and collateralized loan obligations — tend to get their money from investors willing to wait for payouts or share in losses. To some extent, this should lessen their vulnerability to runs. Greater diversity of financial institutions might even be beneficial.
Yet the picture can change quickly. Just about every part of the shadow-banking industry — including pension funds and insurers — has recently been taking on more leverage, often in the form of short-term debt. A lot of that funding is coming from traditional banks, effectively tapping into the government backstops designed to protect the regulated sector. As of December 2022, banks in the US had lent more than $300 billion to nonbanks and committed another $1.5 trillion in credit lines. Taken together, that’s nearly triple the level of a decade earlier.
