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Shadow Banking Essay

1249 words - 5 pages

The global finance system is made up of a two-tier system consisting of the traditional banking system and shadow banking. Shadow banking consists of financial institutions that provide lending and banking activities done outside the scope of traditional banking; lending via auto loans, consumer loans and mortgages. Where traditional banks utilize cash deposits in order to raise capital, shadow banks sell securities on the market by means of the repo (repurchase) market where “collateral that can be rehypothecated” or traded for capital to then be repurchased at a later date. (Gorton, 14) This fact limits the amount of lending traditional banks can do leaving a void and perhaps opportunity ...view middle of the document...

Key elements include a required level of liquidity and the creation of the Federal Deposit Insurance Corporation or FDIC. In fact, since depositors are aware of the insurance on their deposits, they are secure in leaving their money at the bank whereas in the case of the shadow banks, investors know that the value of their investment is only as good as the contents of the security. If they therefore become concerned about its value, they will then pull their money out causing a run where the financial institution is drained of its capital.

Therefore, although shadow banking provides consumers many services traditional banking cannot, the lack of regulation allowed financiers to manipulate the system and cause the economic crisis of the last few years. In the mortgage industry, for example, consumers were offered low teaser rates that enticed them into taking variable interest rate loans that would then increase and become unaffordable. As the loans became unaffordable and consumers defaulted, the securities they were tied to began to lose value. Fannie Mae and Freddie Mac, for example, were in fact backed by the U.S. government and were not subject to the same regulations as private funders. Both companies, known as government-sponsored enterprises or GSE’s, enjoyed the safety net of the government while beginning in 1993 were required by the U.S. government to give 30% of their loans to consumers below the median income, increasing to 40% in 1999 and on up in the 2000’s. (Roberts, 24) This deregulation spurred the growth of the shadow banking system.

The biggest culprit of these loans was the mortgage loan. With such low interest rates, not only were consumers lured into buying houses they couldn’t afford, they were also enticed into using their homes as cash machines, taking out refinance loans. These “new subprime mortgages rose from $160 billion in 2001 to $600 billion in 2006” during which time mortgage brokers were being offered incentives of up front commission to lend to people who could not afford the mortgages, without good credit or even proper income. Lending of subprime mortgages increased so much that by 2006, they made up one fifth of the mortgage business. (Blackburn, 73) Unfortunately, the speculative tide that had overtaken the economy began to decline in August of 2007 as the mortgage backed securities lost their value. (Blackburn, 70) Without the protections of insured deposits afforded the traditional banks set forth in their regulations, the shadow banking industry experienced a run as investors pulled out. During the same period, high interest credit cards, consumer loans and teaser rate mortgages were being offered to consumers. Consumer debt was at an all time high with Americans believing they could afford a rich life on an average income. All these factors came together at once bringing down large shadow banks like...

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