Nonbank financial institutions that make up the largely unregulated “shadow banking sector” pose serious risks to the U.S. financial system. Their growth in size, scope, and interconnectedness over the last decade has made them an increasing threat to financial stability and the safety and soundness of the regulated banking sector. The experiences of the 2008 financial crash and the 2020 pandemic-caused market stress have demonstrated that the risks in the shadow banking sector significantly exacerbate the pace and depth of market stress, spillover directly into the banking sector, and threaten to virtually shut down key financial markets and the economy.
The report provides an overview of the structure of and risks within the shadow banking sector as well as actions financial regulators could take to mitigate risks to the U.S. financial system. This report will be followed by other reports that examine these elements further. Specifically, we:
- Demonstrate how shadow banks generally perform the same or similar activities as regulated banks that carry the same risks, especially under stress;
- Discuss the ways in which the risks in the shadow banking sector exacerbate stress in the financial markets, further straining the cost and availability of funding for individuals, corporations, banks, and other shadow banks;
- Outline which shadow banking institutions were significant contributors to the 2008 and 2020 market turmoil based on the emergency facilities created by the Federal Reserve; and
- Provide high-level recommendations for regulatory reforms to enhance the resiliency of the overall financial system to periods of stress.
As we conclude in our report, without sufficient regulation of the shadow banking sector, minimum regulatory requirements for banks must be stronger to compensate for the spillover of shadow banking stress into the banking sector. Ideally, the regulatory agencies, with the FSOC in the lead, must act in the wake of the 2020 pandemic stress to reduce the risk in the shadow banking sector. Taxpayers and the government have had to provide massive support to the shadow banking sector twice in just over a decade. It is past time for those nonbanks to be forced out of the shadows and be regulated like banks.