Enrico Perotti — The roots of shadow banking

The ‘shadow banking’ sector is a loose title given to the financial sector that exists outside the regulatory perimeter but mimics some structures and functions of banks. This column introduces a new CEPR Policy Insight that looks into what we have learned about shadow banking since the Global Crisis. 

Shadow banking operates outside the regulatory perimeter, but it replicates the structure of banking in many ways. As such, its prudential standards should be brought into alignment to avoid further regulatory arbitrage. Shadow banking assets at the time of the crisis had grown larger than the banking sector proper. The rapid withdrawal of funding to this segment played a major role in the credit crunch of 2007-2008.

My new CEPR Policy Insight No. 69 updates and fleshes out the analysis in my June 2012 Vox column (reproduced in full below). The Policy Insight reviews recent work that is finally shedding some light on this ill-defined and poorly understood segment of the financial system.

The Policy Insight offers a structural definition of shadow banking activities, showing that even proper banks use them to avoid stricter capital requirements. The decision by the Basel committee in these days to accept a relaxed definition of the leverage ratio, for which banks lobbied fiercely, appears a serious setback.

Vox.eu
The roots of shadow banking
Enrico Perotti | Professor of International Finance, University of Amsterdam and CEPR Research Fellow

Very simple to understand account of derivates and their role in credit creation.