$13 Trillion in Obligations Show Shadow Banks Still Threat to Financial System

A report issued by the Federal Reserve Bank of New York shows that so-called "shadow banks" still hold more obligations than regular banks, representing a continuing threat to the financial system.

Three years after the beginning of the financial crisis, the shadow banking system had about $16 trillion of obligations in the first quarter, compared with $13 trillion for banks, the report said. The gap has narrowed from 2008, when obligations were $20 trillion and $11 trillion, respectively.

Throughout the early part of the decade, shadow banks grew in importance as they acted as intermediaries between investors and borrowers.   Familiar examples of shadow institutions include Bear Stearns and Lehman Brothers, which were swallowed by the financial crisis, as well as Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

While this system became a huge and vital source of money to fuel the housing market and the rest of the U.S. economy, the subprime mortgage crisis and ensuing credit crunch exposed a major flaw.

While acting like banks, the shadow banking entities weren't subject to the same government supervision, so they didn't hold as much capital to cushion against potential losses.

And unlike regulated banks, which can borrow directly from the government and have federally insured customer deposits, the shadow system didn't have reliable access to short-term borrowing during times of stress.

When the credit markets dried up in 2008, they were caught in a squeeze as they struggled to liquidate long-term assets to repay short-term loans they had taken from money market and commercial paper markets.

The Fed quickly jumped in and helped JPMorgan Chase & Co. (NYSE: JPM) acquire Bear Stearns. To prevent further damage to the financial system, the Fed also started lending directly to brokerage firms for the first time since the Depression.

"They stepped in because Bear was facing a traditional bank run -- customers were pulling short-term assets and the firm couldn't sell its long-term assets quickly enough," James Hamilton, professor of economics at the University of California, San Diego, told MarketWatch.

"These things act like banks, but they're not," he said. "The fundamental inadequacy of their own capital caused these problems."

In order to keep the financial system functioning, the U.S. government has had to lend, spend or guarantee $11.6 trillion to bolster the financial system, according to data compiled by Bloomberg News. That included agreeing to backstop exotic shadow obligations such as asset-backed commercial paper, collateralized debt obligations and money market funds that helped finance home mortgages, credit card borrowing and auto loans.

The report is aimed at aiding regulators and policymakers as they consider how much oversight to levy on financial markets and will be released in stages for comment.

The Fed and the SEC are requiring banks to bring many of these obligations onto their own balance sheets. As that happens, the shadow banking system will disappear, according to Christopher Whalen, managing director at Institutional Risk Analytics.

"It's an interesting historical document, but if anything it's a great illustration of what the Fed did wrong," Whalen told Bloomberg.

Given the size of this parallel banking system and its vulnerability to further panics, "it is imperative for policy makers to assess whether shadow banks should have access to official backstops permanently, or be regulated out of existence," the Fed researchers wrote.

In order to mitigate future financial crises, the Senate on Thursday passed a financial reform bill in a 60-39 vote, following House passage last month.

Democrats say the bill will cut the odds of another crisis and better handle one when it arrives. They also contend it will restore confidence in U.S. financial markets, protect consumers and spur growth while putting an end to taxpayer-funded bailouts of banks.   

But the bill doesn't tackle Fannie and Freddie, and that leaves some wondering whether it addresses the fundamental problems presented by the shadow banking system.

"Distilled to its essence, the Dodd-Frank Act's task is to address the increasing propensity of the financial sector to put the system at risk and be eventually bailed out at taxpayer expense," Viral V Acharya, Professor of Finance at the Stern School of Business at New York University wrote on Friday in the Financial Times.

But by failing to address problems at Freddie and Fannie and other shadow entities, "implicit government guarantees for large parts of the shadow banking sector remain unaddressed." Acharya wrote.

"The Dodd-Frank Act is right in charging depository banks to build party walls. But alas the party can - and did - happen elsewhere in the shadow banking system," he wrote.

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