Welcome to Shadow Banking Illuminated. The purpose of this site is to provide an inside look into the mysterious realm of shadow banking.

What is a Shadow Banking System?

The traditional banking system is based on borrowing short-term from other banks and lending long to the retail consumer. With that model in mind, we can see how the shadow banking system is essentially the banking system of the corporate world. 

The shadow banking system provides a cheaper and more efficient system for corporations to meet their short-term funding needs.The short-term nature of the shadow banking system allows for corporations to put
up collateral ( Long-term AAA debt) in order to borrow short term funds (ABCP/Repo).  The special purpose vehicle (SPV)  is an entity that holds the collateral and issues securities for the investors (who act as lenders to the corporation) to purchase. Problems arise in the shadow banking system when securities used for collateral have their ratings questioned and the rest of the participants, who lend and borrow from each other, in the system begin to require more interest  in exchange for higher risk. When this occurs, the market loses its efficient and cheap qualities that make these markets so attractive for corporations.


We argue that repo and ABCP programs are predicated on information-insensitive debt and demand deposits, utilizing real-time valuation that produces a cheap, highly liquid, and efficient alternative to traditional short-term lending. Just like banks prior to the Great Depression, this modern day shadow banking system is based on confidence and trust among the participating financial institutions.  When the participating financial institutions begin to see confidence erode in these markets and questions arise regarding the valuations of assets on institutions books, the result can be a modern day bank run.    We think that shadow banking essentially performs the same functions as a regular bank, yet is able to do so more quickly and cheaply. This explains its rising popularity in the past couple decades. Its wide-spread use and lack of common information make it a very fragile system. Thus, it is also our belief that the shadow banking system needs to be properly standardized and accounted for.

Mark-to-market accounting allows for the increase in asset values during the “boom years” which creates a large demand for more debt issuance facilitated through the securitization markets.  The increase is debt issuance leads to record high leverage ratios at various financial institutions. 

Commercial paper and repo markets all rely on confidence in order to function properly.  When asset prices begin to fall (as a result of mark-to-market accounting) and confidence begins to deteriorate, the markets for products like commercial paper and repurchasing agreements begin to freeze up.  Institutions cannot turn over their commercial paper or repurchase agreements and begin to experience liquidity crunches. 

When financial institutions begin to have problems in the short term funding markets, this can lead to runs on banks because other institutions are unwilling to trade with them or lend to them and they see large flows of capital out of their institutions rendering them insolvent.       

To learn more, click on the links above to get a more comprehensive  explanation of some of these issues.