Financial bubbles are a branch of doom thinking or even conspiracy theories; until they burst. Now ten years ago, stock markets dramatically plunged after Lehman Brothers fell. In 2008-2009 more than four million mortgage delinquencies ended in residential foreclosures and the overall economy tanked. Subprime mortgages had been spread out as weed among too many intermediaries within the financial system.
The over-reliance on debt and financial leverage during the 1990s and 2000s, allowed by humble regulatory oversight, fueled precarious and contagious dependencies between intermediaries. These interdependencies and excess leverage largely disappeared after they exploded with the 2007-2008 financial crisis. And financial intermediaries still fulfill crucial functions.
The financial crisis had significant regulatory consequences for financial intermediaries such as large insurance companies and banks. Banks as credit intermediaries and maturity transformers are stronger regulated and bound to stricter capital requirements than under pre-crisis regulation. This created more leeway for "shadow banks" that offer these banking-like intermediation services without being legally qualified as a bank, and thereby not bound to the same prudential banking regulation. Law professor Katherine Judge argues that this "hybrid" model of shadow banks, operating outside the banking regime while fulfilling banking-like roles, has a byproduct of "information gaps"; "pockets of information that are pertinent and knowable but not currently known" to any (private or public) party. The emergence of shadow banking is often considered one of the key drivers of the financial crisis. The events of 2008 "revealed that many of the money claims issued in [the shadow banking] system were less safe than holders previously believed", which eventually "did cause the system to contract", according to Schwarcz. As then US Fed Governor Randall Kroszner noted, "In the old days, we used to know where the risks were; unfortunately, we knew that they were all on the bank balance sheets. With the originate-to-distribute model and securitization [that characterizes the shadow banking system], the risks are much more dispersed." [I]t leads to potential pockets of uncertainty, and that is exactly what has come up. People don't have as much information as they thought they had.
The game changed with stronger regulatory oversight and new financial regulation such as the US Dodd-Frank Act and worldwide Basel III framework. So today, with the lessons from the past, are crises less likely?
Difficult to say. Many claim the financial crisis was a crucial turning point in the long term: setting the stage for a "new normal" in which credit growth, economic growth, wage growth and inflation are lower. The US president urged "to get rid of Dodd-Frank" and shadow banking, often blamed for the financial crisis, is back on track.
Shadow banking is examined by the Financial Stability Board (FSB), an international organization that monitors financial risk globally. Their most recent study from May 2017 shows that shadow banking is back at pre-crisis levels. Also research by Buchak et al. finds that shadow banks profited significantly from the traditional banks being plagued by this post-crisis regulatory burden.
Yet, shadow banking is not necessarily only negative. They benefit the system where they innovate the conservative banking sector and diversify the source of bank-like services such as credit facilitation. The point is that, under the current framework, shadow banking increases information asymmetries that are known uncertainties in the market. In the shadows, where regulation is not too watertight.
Before appropriate regulation, adequate information is needed as to the role of shadow banks. The FSB research and many other studies focus on the size and interconnectedness of shadow banks to assess their risk. Yet, definitions are crucial for any research on size. The FSB frames shadow banks as the most risky subset of "other financial intermediaries". The question here however, is again the riskiness of unknown risk, which manifested during the financial crisis. In that sense it might not be the size of shadow banking that matters, but their interdependency with other financial intermediaries - as simplified on the right.