Explaining Southern California's economy

What is 'shadow banking?'

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The JP Morgan Chase building in New York City. These guys invented financial risk management and have a stake in the future of the "shadow banking" system.

You may have heard the term "shadow banking" or "shadow banking system" in the years since the financial crisis. If you're like most people, it's unclear what it is. It might even be completely incomprehensible and possible sound sort of menacing. It sounds like something out of "Babylon 5." Science-fiction banking.

Now Bryan J. Noeth and Rajdeep Sengupta of the Federal Reserve Bank of St. Louis have produced an essay that doesn't just explain shadow banking — it questions whether it should exist and answers that question. The essay contains this fairly succinct breakdown of the different between the old-school traditional banking system and shadow banking:

Financial intermediation has moved from an originate-to-hold model of traditional banking to an originate-to-distribute model of modern securitized banking. Economist Gary Gorton argued in a book last year that deregulation and increased competition in banking rendered the traditional model of banking unprofitable. In modern banking, origination of loans is done mostly with a view to convert the loan into securities—a practice called securitization, whereby the transaction, processing and servicing fees are the intermediaries' principal source of revenue.