Most people now realize big banks aren’t their friends. Only in the fairy tale movie world of It’s a Wonderful Life does banker George Bailey lend a helping hand to friends and neighbors to build a prosperous Bedford Falls.
But many people have no idea that the regulated banking system is only one part of a gigantic problem. Lurking behind regulated banks is the shadow banking system. And it’s from out of these shadows that the next big shock to the global financial system, threatening everyone’s nest egg, might come.
What is shadow banking? Different writers mean different things when they use the term. But the fact that it’s hard to explain only makes it more difficult to constrain.
For our purposes, “shadow banking” is the loosely regulated or unregulated portion of the financial system outside the boundaries of the large and well-known commercial and investment banks. The shadow banking system includes shadow banks, such as hedge funds, and shadow practices, such as inadequately regulated derivatives. This system is vast, and grew by a factor of five between 1990 and 2011, so that it now represents more than 15 trillion dollars in liabilities, according to a staff report by the Federal Reserve Bank of New York. Shadow banking liabilities exceed those of the formal banking sector, and are currently about equal to the entire U.S. gross national product.
Why does it matter? Because this system is too big to fail — so you may end up footing the bill if something goes wrong.