Much Ado About the Shadow Banking System
Occasionally, a blog post will flower into a wide-ranging debate in what is usually called the "economics blogosphere." Last Friday's guest post on regulation by Mark Thoma triggered just such a debate.
I'll quote the controversial passage at some length:
Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.
The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.
We need to bring the shadow banking system – essentially any institution that takes deposits and makes loans either directly or indirectly – under the same regulatory umbrella as the traditional banking system.
Dr. Manhattan, an anonymous blogger at The Atlantic, focused on that middle paragraph in a post called "Sentences That Don't Compute," arguing that the crisis was due to problems at regulated financial institutions, such as AIG, not the shadow banking system.
Brad DeLong defended Thoma, drawing the line between commercial deposit-taking banks (heavily regulated) and other institutions (lightly regulated).
Thoma also responded on his own blog, pointing to the fact that AIG's problems, for example, were caused by the unregulated part if its business - the Financial Products derivatives-trading business.
Finally, Rortybomb has a careful review of the issues, showing how different people mean different things by "shadow banking system." Ultimately he sides with Thoma on this point: money shifted into a sector of the financial system where there was no backstop against a liquidity crisis - unlike the regulated operations of the commercial banks, where deposit insurance plays that role. This is a problem that needs to be fixed.
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