In recent decades, a parallel universe sprung up in American finance -- a new way for the finance industry to perform its traditional role of linking savers with borrowers. It's often referred to as the shadow banking system.
This system was at the heart of the financial crisis -- and, according to a new paper from the New York Fed, it's still bigger than the traditional banking system.
In all, there's still some $16 trillion sloshing around the shadow-banking system, more than the entire gross domestic product of the U.S.
Shadow banking involves lots of the arcane stuff that came to define the crisis -- securitized loans, CDOs, the repo market. But it also involves the money-market mutual funds that have long been familiar to ordinary investors, and that provide much of the cash that keeps the system flowing.
While the housing bust was the catalyst for the financial crisis, the acute phase of the crisis was defined by a run on the shadow banking system: All of the savers/lenders wanted their money back, all at once.
Banks can't survive when that happens -- particularly if they're heavily dependent on short-term loans. That's why Lehman Brothers and Bear Stearns ceased to exist.
In the heat of the crisis, to stop the run on the shadow banking system, the Federal Reserve issued guarantees to key parts of system, including money-market mutual funds.
Since then, there have been lots of questions about why the Fed and other regulators let the shadow banking system become so precarious in the first place.
In its new paper, the New York Fed argues that regulators should focus on what financial institutions actually do, rather than on whether or not institutions are officially designated as banks.
In other words, the paper suggests, shadow banking is subject to bank runs just like regular banking, and should be subject to some of the same kind of regulations.
The finance bill Congress is about to pass seems to dovetail with this conclusion: It gives officials the power to regulate non-bank financial institutions whose failure could cause widespread economic problems.
Hat Tip: Economist