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What is 'shadow banking?'

The JP Morgan Chase building in New York City. These guys invented financial risk management and have a stake in the future of the
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.
Chris Hondros/Getty Images

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.

That's about as a good a definition of securitization as you're likely to get. 

The rest of the essay isn't as easy to digest. But the upshot is that Noeth and Sengupta argue that although there was a run on the shadow banking system during the financial crisis, exposing its fragility, it shouldn't be done away with. They have a point. Securitization did solve the problem of declining profitability for the traditional banking business.

Unfortunately, it also made those same traditional banks — whose deposits were backed up by FDIC insurance — vulnerable to the very systemic risk that the securitization process was supposed to be eliminating. Noeth and Sengupta don't really spell this out, but by drawing a clear parallel between the role that deposit insurance has played in making the traditional banking business sturdier — preventing bank runs — they imply that the shadow banking system should be similarly protected. 

They write that we need to "harness the benefits and mitigate the risks and redundancies of such a parallel banking system," but they don't discuss how that would happen. But if we want to keep securitization around, we're going to need to figure that one out.

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