Reform bill grazed past shadow banks

Marketplace Staff Jul 14, 2010

Reform bill grazed past shadow banks

Marketplace Staff Jul 14, 2010


Kai Ryssdal: If small banks are in trouble, all indications point to the big guys doing pretty well. We’ll learn just how well tomorrow morning, when JP Morgan starts the banking quarterly profit parade. But small bank failures and booming business at the likes of JP Morgan are only half the story. A new report out from the Federal Reserve Bank of New York says the new financial reform bill that’s in Congress now barely touches on a key part of the financial industry, what’s called “shadow banking.”

Our senior editor and wizard of the Marketplace Whiteboard Paddy Hirsch is here. Hello Paddy.

Paddy Hirsch :How are you doing?

Ryssdal: I’m well. First things first, I suppose we need a definition. Shadow banking is…?

Hirsch: Well, shadow banking is, banking. I mean, shadow banks are organizations that lend money to people just like traditional banks do. So, the difference between traditional banks and shadow banks in that respect is minimal, there’s no difference between them.

The difference comes, however, when you talk about who actually puts their money into these banks, because banks obviously take money in and then lend money out. In a traditional bank, that money comes in from depositors. In a shadow banking system, that money comes from investors, not depositors, not people like you and I, but investors who want to invest in that company.

Ryssdal: Are there names of entities within the shadow banking world that we would recognize?

Hirsch: Well, sure two classics are Lehman Brothers and Bear Stearns. Those big investment banks were part of the shadow banking system. The people that put money into Lehman and Bears were not depositors like you and I, they were regular investors.

Ryssdal: Gimme a sense of scale here though. I mean, how big is this shadow banking system?

Hirsch: Well, it’s enormous. Back in 2008, two-thirds of the loans that were lent out to Americans were lent by the shadow banking system. Today, it lends about $16 trillion to Americans, and that’s just over half of the amount of money that’s given to Americans altogether.

Ryssdal: Sixteen trillion is just for the record, bigger than the whole American economy.

Hirsch: There you go.

Ryssdal: You know, you say shadow banking and it implies something nefarious, not necessarily on the up and up.

Hirsch: Well, it’s not that it’s not on the up and up. But the difference is that traditional banks are very very tightly regulated. They’ve been in existence for a long time and regulators have really got a grip on these things. Shadow banks haven’t been around that long or the shadow banking system hasn’t been in existence that long, so the regulations are a lot looser and they are a lot freer to do things like, you know, borrow pots of money and invest them in potentially risky securities.

The other thing is, traditional banks have this thing called deposit insurance. So if things go wrong with a traditional bank, you’re going to get your money back or most of it if you’re protected. Shadow banks don’t have that kind of protection. So if there is a hint of trouble, investors in those organizations are going to run for the hills, and that can kill a bank over night as it did with Bear Sterns and Lehman Brothers. And because the banking system we now know is so interconnected, that can bring the whole system down with it.

Ryssdal: Alright, so there’s this report from the New York Fed that I talked about at the top. What are we doing about this banking system, this shadow banking system?

Hirsch: Well, the way the New York Fed sees it, we’re in danger of not doing enough. The report says the shadow banking system got this huge bailout that brought it out into the daylight for awhile, but none of those banks have paid that money back. They’ve escaped back into the shadows and possibly out of the reach of the regulators.

So what the New York Fed says is what needs to happen is that the people who actually craft the specific rules they need to recognize that shadow banks do the same thing as traditional banks. They lend to consumers, they lend to Americans, and therefore, they should be treated the same way. Unfortunately, given what we’ve seen with the auto lenders, it looks like that’s not really going to happen and that’s putting us in danger of creating the same risky lending environment that we had before the crash.

Ryssdal: Expand on that a little bit. Because the Senate is going to vote tomorrow on this big financial overhaul bill. What’s in there that might at least control the shadow banks?

Hirsch: Well, we still don’t really know that much because a lot of these rules have to be written in detail. You know, the bill gives us the general outline, but the regulators have to sit down and actually craft the very specific regulations, which themselves are going to be enormous, as enormous as the bill is. So until that is done, until the regulators have actually decided, what is a bank, in inverted commas, as it is referred to in the bill, we’re not going to know that.

Ryssdal: We’re still trying to figure out what a bank is.

Hirsch: In a way, yes, that’s exactly what we’re trying to do.

Ryssdal: Our senior editor Paddy Hirsch. You know him best through his series of Whiteboard explainers of every size, shape and texture. Including one as it happens on the shadow banking system. You can see it on our homepage, it’s Paddy, thanks a bunch.

Hirsch: Thank you, Kai.

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