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CRS – Shadow Banking: Background and Policy Issues

Shadow Banking: Background and Policy Issues, Edward V. Murphy, Specialist in Financial Economics, December 31, 2013.

“One view of the financial crisis of 2007-2008 is that it was not centered in traditional banking. The term shadow banking “ … refers to credit intermediation involving leverage and maturity transformation that is partly or wholly outside the traditional banking system.” That is, shadow banking substitutes at least partially for simple banking in the creation and funding of debt. Several components of the shadow banking system contributed to the breadth of the financial turmoil that began in 2007, and the magnitude of the financial panic in September 2008, according to the Financial Crisis Inquiry Commission (FCIC). In response, regulatory policymakers have been analyzing how the shadow banking system works, and considering options to promote greater financial stability in shadow banking.4
Congress is considering several shadow banking regulatory reform proposals (e.g. changing the status of repurchase agreements [repos] in bankruptcy proceedings), overseeing related agency rulemaking
(e.g., regulations for Money Market Funds [MMFs]), and overseeing the implementation of related financial reform legislation (e.g. applying the capital requirements in Section 171 of the
Dodd-Frank Act to nonbanks).  This report develops a general framework for analyzing financial intermediation, and applies these concepts to several specific shadow banking sectors. The report focuses on comparing and contrasting the fundamental economic problems of simple banking (which will be referred to as luminated banking) and associated policy responses to analogous problems and policy proposals in shadow banking. Shadow banking provides a similar general service (financial intermediation) as luminated banking, and is subject to similar fundamental economic problems. Furthermore,
many of the proposed regulatory responses for shadow banking have policy trade-offs analogous to regulatory policies in banking, and some shadow banking sectors already have a financial regulatory regime (such as securities regulations). Many of these economic problems and potential policy responses are illustrated by the experiences of five shadow banking sectors (repos, nonbanks, asset backed commercial paper [ABCP], securitization, and MMFs) during 2007-2008, and by regulatory responses currently being considered.”

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