Shadow banking, the subject of some high-profile hearings in Washington this week, is not nearly as shadowy as its name suggests. Basically, it's the way big investment banks and other finance companies borrow money.
The system is largely unregulated. And, before the crisis hit, it was huge. Corporations and other big institutions with lots of cash loaned out trillions of dollars.
During the crisis, the shadow banking system led to old-fashioned bank runs on Lehman Brothers and Bear Stearns; lots of the institutions who lent to the investment banks asked for their money back all at once. Banks generally can't survive when that happens.
The runs on Bear and Lehman didn't come out of the blue, says Phil Angelides, who chairs the commission that's holding the hearings.
There was "some pretty clear evidence that this was a very fragile system ready to come apart at any moment," he says in an interview on All Things Considered.
For every dollar it had in equity, Bear Stearns borrowed another $40. In all, the bank borrowed about $400 billion. What's more, about $50 billion of that was in loans that the bank had to renew every day, Angelides says.
He compares Bear's situation to a family that has $50,000. The family borrows an additional $2 million, including $300,000 in loans that come due every day. It's easy to imagine the system falling apart.
Bear Stearns's former CEO, James Cayne, will testify tomorrow, along with two former SEC chairmen. Hank Paulson and Tim Geithner, among others, will testify on Thursday.
Gary Gorton, a Yale finance professor I spoke to a while back, said the finance bill being debated in the Senate is unlikely to prevent future runs on the shadow banking system.
Runs on commercial banks happened again and again in this country in the 19th and early 20th centuries; they only ended after the federal government created deposit insurance, after the Depression. But applying that solution to shadow banking wouldn't work, because the sums of money used to insure deposits would have to be too vast, Gorton said.
"The tidal wave of this kind of crisis is so big that any pool of money you have is like a small useless war chest," he said. "It's never going to be enough."