The shadow banking system or the shadow financial system is largely formed by non-bank financial institutions that, like banks, borrow short and in liquid forms and lend or invest long in more illiquid assets[1]. They are able to do this via the use of credit derivative instruments which allow them to evade normal banking regulations, e.g. those related to specifying ratios of capital reserves to debt.
The term "Shadow banking system" is attributed to Paul McCulley of PIMCO by the latter's Bill Gross[2].
Several new institutions and vehicles have emerged in American and European markets this decade that have come to play an important role in providing credit across the financial system.[3] Until summer 2007, structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) attracted little outside attention. Often affiliated to major banks, they are not always fully recognised on balance sheets.
The system includes SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. These institutions are subject to market risk, credit risk and especially liquidity risk, since their liabilities are short-term while their assets are more long term and illiquid.
As they are not depositary institutions, these entities do not have direct or indirect access to the central bank's lender-of-last-resort support. In conditions of market illiquidity, they could go bankrupt if unable to refinance their short-term liabilities.
The shadow banking system has been blamed[4] for aggravating the subprime mortgage crisis and helping to transform it into a global credit crunch.[5]
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