What Is Shadow Banking?

Shadow Banking Explained

Banks deal with billions of dollars daily, much of which are guaranteed by governments, but are subject to some of the most stringent laws and regulations in the world. These large dollar amounts makes figuring out ways to bend or avoid those stringent laws extremely profitable. Companies that do so are often referred to as taking part in the shadow banking system. The group of companies and markets that carry out traditional banking activities outside of the traditional banking regulatory framework.

Shadow Banking Made Easy

In the United States, a bank is a company that takes demand deposits from savers and then loans that money back out to borrowers. Savers are OK with this because the FDIC guarantees those deposits. Even if the borrower does not repay the bank, the US government will make sure the saver gets 100% of their money back. This guarantee comes at a price though; banks are limited in how big of investments they can make, who they can make them to and what type they can be; often having to pass on the most lucrative of opportunities.

Exceptions of Shadow Banking

If a company does not take demand deposits, they are not subject to those rules though. Hedge funds, private investors and private equity funds fit this category. The entities raise the majority of their cash through loans, bonds and issuing commercial paper; not demand deposits.

Shadow Banking Purpose

The shadow banking system provides market liquidity in transactions that only involve professional investors; they do pose some major risks though, some of which lead to the 2008 financial crisis. For example:

  • Shadow banks do not have to report their internal accounting figures to the government, meaning it is harder to track and monitor them.
  • Shadow banks do not have access to the Federal Reserve’s emergency lending window, meaning that in times of crises and market tightening, their cash sources will dry up quickly.

Shadow Banking FAQs

Shadow banking refers to companies and markets that carry out traditional banking activities outside of the traditional banking regulatory framework.
In order to evade FDIC loan restrictions, shadow banks cannot accept demand deposits.
The entities raise the majority of their cash through loans, bonds and issuing commercial paper; not demand deposits. Hedge funds, private investors and private equity funds fit this category.
The shadow banking system provides market liquidity in transactions that only involve professional investors.
Shadow banks do not have to report to the government, meaning it is harder to track and monitor them. Shadow banks also do not have access to the Federal Reserve’s emergency lending window, meaning that in times of crises and market tightening, their cash sources will dry up quickly.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.