Shadow Banking and the Next Financial Crisis

December 10, 2013
By Kevin Rowe MPP 2014

Banks are hardly the only financial institution engaged in traditional banking activities, yet in most countries banking by non-bank institutions – known as shadow banking – is not governed by the same rules or the same regulators as commercial banks.
Inadequate regulation of shadow banking by institutions like money market funds likely contributed to the 2008 financial crisis, and as former Deputy Governor of the Bank of England Paul Tucker argued at the Regulatory Policy Program Seminar on November 14, it may be the cause of the next crisis.
Tucker, who is a senior fellow at the Mossavar-Rahmani Center for Business and Government at Harvard Kennedy School (HKS) and a senior fellow at Harvard Business School, described shadow banking as “probably the greatest problem that will be created by finance in the next decade or two.”
While the United States, United Kingdom, and several other countries have made modest attempts to improve oversight of shadow banks, safeguarding the global financial system against systemic risks posed by these activities will require more comprehensive reforms.
Tucker identified two main challenges to achieving these reforms, especially in the U.S. system. First, the regulatory agencies that oversee the markets in which shadow banks operate must focus on transparency and fairness in financial activities, not systemic stability. The myriad set of regulators and relevant regulatory authorities in the U.S. context provides opportunities for regulatory arbitrage by such shadow banks. Second, while recent reforms allow regulators to regulate non-bank institutions like banks if they are deemed systemically significant, many of the risks posed by shadow banking are generated by chains of transactions across many institutions rather than any single institution.
The Fall 2013 New Directions in Regulation Seminar series is sponsored by the Regulatory Policy Program at the Mossavar-Rahmani Center for Business and Government.

Paul Tucker, senior fellow at the Mossavar-Rahmani Center for Business and Government

Paul Tucker, senior fellow at the Mossavar-Rahmani Center for Business and Government

“Probably the greatest problem that will be created by finance in the next decade or two.”


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