Before getting into an analysis of how the shadow banking system played a role in the 2008 economic downturn, we must first understand what this system is in the most basic sense. Although the term “shadow” may conjure up all sorts of nefarious and unpleasant images in one’s mind, it would simply be unfair to characterize this aspect of our financial system in such an emotional or negative context. (Four major players slice and dice your mortgage in the secondary market.
We all know the traditional banking system provides checking and savings accounts, auto and home loans, and various other financial services. But most people fail to understand that these institutions do not possess infinite capital, and are therefore limited in the amount of loans they can provide to consumers or small businesses. This limitation is where the shadow banking system came into play.
The Rise of Shadow Banking
Prior to the Great Recession, banks realized their ability to profit from lending was limited by access to capital and the size of their balance sheet. So instead of lending and holding loans like banks did in the “good old days” (limiting profit potential), they began specializing in originating loans, packaging them and selling them to other investors through securitization processes via investment banks; hence the inception of the unregulated “shadow banking system” which provided a conduit capital seeking to purchase these securities.
How this worked is rather simple. A financial institution would lend as much money as possible for home, general consumer and auto loans, and would then work with investment bankers to securitize these pools of assets. These securities would then be sold to a variety of investors such as pension funds, endowments, mutual funds, hedge funds and other financial institutions; these were the funders of the shadow system. These instruments could take a great many forms such as asset-backed securities (ABS), collateralized debt obligations (CDO), mortgage-backed securities (MBS) and collateralized loan obligations(CLO).
It was through these instruments that more and more people were easily able to access credit as financial institutions could profit from making ever increasing amounts of risky loans. This led to the lending institutions selling these loans to other investors in the form of innovative fixed-income securities. So it seemed a win-win situation for everyone involved. Consumers got the cheap credit they desired and investors found a way to earn higher returns over Treasuries with minimal perceived risk in the face of robust and stable economic growth.
