Out of the shadows: an overview of the shadow banking system
by Ingrid Goodspeed
Governor of the South African Institute of Financial Markets

he best dike is of little use when there is a whole ocean at your back. This ocean is the so-called shadow banking sector: the part of the financial system that is not subject to regulation, that has been inviting regulatory arbitrage and that has been a significant amplifier of risk during the financial crisis.”

Axel A Weber, President of the Deutsche Bundesbank

The objective of this article is to give an overview of the shadow banking system. Firstly it will define shadow banking and the entities that make up the system. Secondly the contribution of the sector to systemic risk will be discussed. Finally, international initiatives to strengthen the oversight and regulation of shadow banking will be described.

Shadow banking defined

Shadow banking refers to non-banks carrying out bank-like activities – maturity(1), credit(2) and liquidity(3) transformation - with limited (if any) supervision and regulation and no formal access to safety net mechanisms such as emergency liquidity funding or lender-of-last-resort facilities and deposit insurance.

Examples of shadow banks include shadow funders such as money market funds, securities lenders and repurchase agreements and shadow lenders such as finance companies, securitisation vehicles, and structured investment vehicles.

Shadow funders

(i) Money market funds

Money market funds are mutual funds (or collective investment schemes) that invest in short-term debt instruments. Investors consider these funds close substitutes for banks deposits, but that accrue a higher rate of interest. However money market funds are investment products and subject to risks such as investment risk(4), not associated with bank deposits.

There are differences among money market funds around the world. For example, in the United States, money market funds would typically refer to investment companies that seek to maintain a stable net asset value (typically USD1 per share) and comply with the regulatory framework of the Investment Company Act, including risk-limiting rules addressing asset quality, liquidity, maturity and credit diversification. In Europe there are two types of money market fund – those with a constant or stable net asset value and those with a fluctuating or variable net asset value. In South Africa money market funds have a net asset value that fluctuates with the value of funds’ underlying assets.

In early August 2007, the suspension of redemptions by a European enhanced-return money market fund was the proximate trigger for the money market liquidity crisis. In September 2008, after the Lehman Brothers’ failure, when the Reserve Primary Fund ‘broke the buck’, there was a run by institutional investors of about USD310billion, which pushed funding markets into chaos. This was exacerbated as many banking groups injected “capital” into their supposedly arms-length money market funds to keep them solvent. In the end the US Treasury stepped in to guarantee up to a limit, the investment in money market funds. In the words of Paul Tucker, “if this sounds like a bank, it is because it is just like a bank”.

(ii) Securitised lending and repurchase agreements

Securitised lending and repurchase agreements can be seen as non-deposit sources of collateralised funding.

Securities lending transactions are over-the-counter transactions that involve the borrowing and lending of securities mainly for the purpose of covering short-sale positions. Financial institutions such as banks and insurance companies lend securities held by their clients to other financial institutions in exchange for cash collateral, and then on-lend or otherwise invest that cash. In this way securities lending can be a large, albeit unstable, source of funding for financial institutions.

Repurchase agreements or repos are short-term over-the-counter transactions between two parties. In terms of the agreement one party borrows cash from the other by pledging a financial security as collateral. Prior to the financial crisis repos were an attractive funding source to lend and invest in relatively illiquid mortgage-backed securities.

While securities-lending and repos have been effective in providing liquidity under normal market conditions, under stress conditions such funding may prove to be a source of liquidity risk. The liquidity risk arising from the unavailability of  securities-lending or secured-repo financing is inherently systemic and materialises in circumstances when investors believe they might need to sell underlying collateral in illiquid markets. This typically occurs when most financial firms are experiencing stress and may result in the markets for assets held predominantly by the financial sector being rendered illiquid.

During the crisis the run on shadow banks in the repo and securities-lending markets was evidenced by increasing haircuts in these markets.

Shadow lenders

(i) Finance companies

Finance companies are non-bank institutions engaged in the extension of credit to firms and households. They do not take deposits. Rather they are funded through the issue of bonds or short-term commercial paper. Finance companies can be captive or stand-alone. Stand-alone finance companies are not subsidiaries of other corporate entities. Captive finance companies are owned by non-financial corporations such as manufacturing companies e.g., white-goods and vehicle manufacturing companies, and homebuilders. They were originally created to provide financing for customers.

During the crisis finance companies were no longer able to depend on demand for their commercial paper from money market funds. Instead they had to rely on committed lines with banks that underpinned their commercial paper programmes. The result was shadow lenders that were dependent on bank funding in unfavourable circumstances without banks necessarily having the wherewithal to support them at such times of systemic stress.

(ii) Securitisation

From the 1970s the credit markets, starting with retail mortgage loans, shifted from the originate-to-hold to the originate-to-distribute model of credit intermediation. Loan originators like banks no longer hold loans to repayment but sell them to new entities, generally called special purpose vehicles (SPVs) or special purpose institutions (SPIs). SPVs package the loans into structured debt securities, some of which are highly complex, and sell these to investors. The debt securities give investors the right to receive borrowers’ interest payments and capital repayment. In this way credit intermediation moved from being deposit funded to capital-market funded in a process known as securitisation. Securitisation is an effective way for banks to move assets off-balance sheet.

A commitment to provide liquidity support is a prerequisite for any securitisation transaction. Liquidity support is provided to the SPV when there is insufficient cash flow from the receivables to meet payments to investors. Liquidity providers are usually banks.

(iii) Structured investment instruments

Structured investment vehicles are entities that earn a spread by issuing commercial paper and medium-term notes and using the proceeds to purchase highly-rated debt securities. These are often used by banks to move transactions off-balance sheet to avoid prudential capital, liquidity and reporting requirements. While SIVs are often sponsored by banks i.e., banks retain effective control, they may not have committed bank lines. Nonetheless during time of systemic stress, SIVs may call upon their sponsors for support.

Systemic risk of the shadow banking system

Prior to the 2007/8 financial crisis the shadow banking sector was not considered systemically important and as it was not subject to the same degree of regulation as the formal banking sector, authorities were unable to monitor the build-up of risk and leverage within the system, and were unaware of the potential spillover effects on the stability of the entire financial system. At the start of the crisis the size of the shadow system had grown almost as large as the formal banking system. Failures here would be and were in fact systemic.

The shadow banking system is a source of systemic risk in two ways:

  • directly through its maturity, credit and liquidity transformation activities. Short term deposit-like funding in the shadow banking system e.g., money market funds, may create bank-like runs that could destabilise and undermine the broader financial system. Also using sources of collateralised funding such as repos, especially when asset prices are buoyant and haircuts are low, can facilitate high leverage (particularly when collateral is re-pledged); and
  • indirectly because it is closely interlinked with the regular banking system. Banks are frequently active participants within the shadow banking chain. In addition, banks often invest in, underwrite or provide liquidity support to the debt securities issued by shadow banking entities.
International initiatives to strengthen the oversight and regulation of shadow banking  

At the November 2010 Seoul Summit, the G20 Leaders highlighted “strengthening regulation and supervision of shadow banking” as one of the outstanding issues of financial sector regulation that required attention. The G20 Leaders requested that by mid-2011, the Financial Stability Board (FSB), in collaboration with other international standard setting bodies, develop recommendations to strengthen the oversight and regulation of the shadow banking system, including those related to the system’s interconnectedness with the regulated banking sector.

In April 2011, the FSB published its background note – Shadow Banking: Scoping the issues, which requested national supervisors to assess credit intermediation outside the regulated banking system that:

  • posed systemic risk particularly in respect of maturity/liquidity transformation, leverage, flawed credit risk transfer. Consideration should be given to the interconnectedness between the shadow and regulated banking system; and/or
  • raised concerns around regulatory arbitrage that could weaken the effectiveness of financial regulation.

Since shadow banking comprises a large number of activities and entities, the FSB believes it is unlikely that a one-size-fits-all regulatory approach for all components of the shadow banking system would be appropriate. However any proposed regulatory response on shadow banking is likely to fall into one of the following four categories:

  • Indirect regulation i.e. regulation of banks’ interactions with shadow banking entities to reduce the spill-over of risks into the regular banking system and minimise opportunities for regulatory arbitrage i.e., for banks to shift activities to shadow banks to avoid high prudential capital and liquidity requirements;
  • Direct regulation of shadow banking entities to reduce the risks they pose to the system;
  • Direct regulation of shadow banking activities to diminish risks of particular instruments, markets or activities; and
  • Macro-prudential regulation to broadly address systemic risk in the shadow banking system e.g., measures for mitigating procyclicality.

In its October 2011 update, the FSB indicated that workstreams have been launched to assess the case for additional regulatory action in five areas: banks’ interaction with shadow banking entities; money market funds; other shadow banking entities; securitisation; and securities lending and repos.


Apart from shining a light on the shadow banking system, the 2007/08 financial crisis provided insights into aspects of systemic risk not previously understood. For example, the financial system has become and is becoming ever more interconnected, which means that promoting systemic stability by regulating individual institutions, instruments  or markets has become increasingly difficult. As a result a macro-prudential approach to regulation has become a prevailing theme in both national and international regulatory reforms. This regulatory approach should encompass improved oversight of the shadow banking industry as restricting the activities of the banking industry (e.g., Volcker Rule) or squeezing the industry though tougher capital and liquidity rules (Basel III) may worsen the risk of systemic instability by pushing even more activities into the unregulated shadow banking system.

(1) Maturity transformation involves issuing short term liabilities (such as demand deposits) and transforming them into medium or long term assets (such as 30-year mortgage loans).
(2) Credit transformation involves matching safe liabilities such as retails deposits with risky assets. Risky assets may range from fairly low-risk assets such as retail mortgage loans to high-risk assets such as commercial real-estate loans.
(3) Liquidity transformation involves issuing liquid liabilities (such as money market instruments) to finance illiquid assets (such as mortgage loans)
(4) Investment risk is the risk of a decrease in the net realisable value of investment assets due to adverse movements in market prices e.g., interest rates, exchange rates, property prices, equity prices, commodity prices, or factors specific to the investment itself e.g., quality of management for equity, location for property.

Bibliography and further reading

Financial Stability Board. 2011 (April). Shadow Banking: Scoping the Issues. www.financialstabilityboard.org. Accessed October 2011.

Investment Company Institute, 2009 (March).  Report of the money market working group. www.ici.org. Accessed October 2011.

Pozsar, Z, Adrian T, Ashcraft A and Boesky H. 2010 (July). Shadow banking. Federal Reserve Bank of New York staff report no.458.  www.ny.frb.org. Accessed October 2011.

Tucker, Paul. 2010 (January 21). Shadow banking, financing markets and financial stability. Speech at a BGC Partners Seminar. www.bankofengland.co.uk. Accessed October 2011.

Weber, Axel A. 2011 (March 10). Lessons learnt: The reform of financial regulation and its implications. Speech at the UCL Economics and Finance Society. http://www.bundesbank.de/download/presse/reden/2011/20110310.weber.en.php. Accessed October 2011.