344: Why Should You Care About Shadow Banking?

Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 344. It’s titled “Why you should care about shadow banking.”

What Is Shadow Banking?

Shadow banking is not something that I have spoken about specifically on the podcast, although we have discussed numerous investments in other vehicles that are a form of shadow banking. Cryptocurrency lending is shadow banking. Investing in a money market mutual fund is shadow banking. Lending or borrowing on peer-to-peer lending platforms is shadow banking. There are many different types. In fact, shadow banking makes up half of the global financial system, according to the Financial Stability Board.

What exactly is shadow banking? Shadow banks are entities that perform some function of traditional banks, but they are much less regulated. They don’t offer depository insurance in case they go bankrupt. Nor do the shadow banks maintain accounts at the central bank, so they don’t get access to central bank funding in its role as lender of last resort.

The Financial Stability Board, which is an international body that monitors and makes recommendations about the global financial system—it’s made up of treasury and central bank officials around the world. They do an annual report on what they call non-bank financial intermediation (NBFI), which is a fancy name for shadow banking.

In their most recent report, they pointed out that the NBFI sector—shadow banks—account for 49.5% of the global financial system. That’s at year-end 2019. And it compares to 42% in 2008.

Shadow Bank Functions

Shadow banks have a number of functions that they play in the economy. The first is as savings and investment vehicles, an investment in a money market mutual fund. A topic that we discussed in-depth in episode 333, “How the Covid shock nearly destroyed the financial system”—that’s an investment in a shadow bank. It’s a saving vehicle, but it’s not FDIC-insured. There is no depository insurance.

Hedge funds are shadow banks. Fixed income funds are a type of shadow bank because they’re lending to corporate entities outside of the traditional banking sector. The primary risk for this savings and investment function of shadow banks are runs on the banks if depositors decide that they wanna pull their money quickly. And that stress can cascade through the system. That was one of our discussion points in episode 333, how the central banks had to step in and provide liquidity and guarantees for the money market accounts so that they were protected and there was not a bank run.

A second economic function of shadow banks is lending. And with any type of lending activity, there’s credit risk, defaults. And there’s liquidity risk because oftentimes the shadow bank is borrowing short-term and lending long-term. And again, they could be susceptible to bank runs.

An example of shadow bank lending activities is supply chain finance, where companies borrow from the supply chain financier to produce and ship goods. We’ll give a detailed example of that in a few minutes.

Prime brokers that lend to hedge funds is an example of a shadow bank. Non-bank home mortgage lenders, like Quicken Loans, which is one of the largest mortgage originators in the U.S. is not a bank. It’s a non-bank, it’s a shadow bank. Payday loan companies are a type of shadow bank.

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