The markets are going strong again, despite the recent correction. The S & P 500 will need to break through overhead supply (previous highs) and then retest those same levels before I’ll give the markets a green light!

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With that in mind, let’s explore the topic of shadow banking and the risks that it entails. Shadow banking can be really good for the economy, yet, if carelessly managed has the potential to bring the financial system down. A definition of shadow banking would include any bank-like activity undertaken by a firm that is not regulated. A traditional bank, in simplest terms,  uses deposits at the bank to lend people money.  Shadow banks get their money from investors and lends it out in the form of car loans, boat loans, home loans, and credit card loans.

The traditional banks are regulated to protect the depositors which in turn protects the banks. The depositors are protected by deposit insurance and if there is a problem with a bank the depositors are less likely to make a run on the bank. Shadow banks have no deposit insurance. If there is a problem with this type of bank, investors are much more likely to ask for their money back. This can cause a run, which could collapse the shadow bank if everyone wanted their money back at once.

In the last 10 years shadow banking has increased from $26 trillion to $71 trillion according to the FSB (Financial Stability Board) or roughly a quarter of the global financial system.

We are seeing more and more combinations of traditional banks and non-traditional (shadow) banks, an example of this would be Bank of America and Merrill Lynch. The danger here is that if the shadow bank is large enough it’s problems could bring both of them down. Traditional banks have been battered by losses incurred during the financial crisis. They have been facing more intense regulation and higher capital reserve requirements. Banks have been cutting back on lending to businesses and consumers and shutting down divisions. The shadow banking system has been filling the gaps with increased lending.

Could it be that the Federal Reserve is paying big banks not to lend? The Fed has, in fact, been paying .25% on the banks excess reserves, paying out billions of dollars of risk free funds directly to the banks. I guess you could say that this was one way of making the banks healthy again. But, this lack of lending has encouraged the growth of the shadow banking system.

There is nothing necessarily wrong with shadow banking and a company taking out a long-term loan from a life insurer with long-term liabilities instead of from a bank. If the loan goes south the creditor loses but without the amount of leverage found in the banking system. Shadow banks, however, if poorly regulated, can be dangerous. One of the principal culprits in the financial crisis was the “structured investment vehicle”, a legal entity created by banks to sell loans repackaged as bonds. They packaged sub prime loans with prime loans by over-collateralizing the loans to get AAA rating from Fannie Mae. When the real estate market started heading south all hell broke loose.

This accelerated growth in the shadow banking mandates the need for regulations to protect our financial system.

Hopefully the Fed knows what it’s doing…..

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