Economists at the Federal Reserve Bank of New York recently released a publication entitled, "Shadow Banking," which was written by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky. The Abstract says, "The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, 'shadow banks' are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises."

It continues, "Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo. This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis."

The authors say, "We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve's discount window, or public sources of insurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve and other government agencies' guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system."

The study, which doesn't spend much time discussing money market funds, includes the following conclusions: "The volume of credit intermediated by the shadow banking system is of comparable magnitude to credit intermediated by the traditional banking system." The paper says, "At a size of roughly $16 trillion in the first quarter of 2010, the shadow banking system remains an important, albeit shrinking source of credit for the real economy. The official liquidity facilities and guarantee schemes introduced since the summer of 2007 helped make the $5 trillion contraction in the size of the shadow banking system relatively orderly and controlled.... While these programs were only temporary in nature, given the still significant size of the shadow banking system and its inherent fragility due to exposure to runs by wholesale funding providers, it is imperative for policymakers to assess whether shadow banks should have access to official backstops permanently, or be regulated out of existence."

It also concludes, "The collapse of the shadow banking system is not unprecedented in the context of the bank runs of the 19th and early 20th centuries." It speculates that "private sector balance sheets will always fail at internalizing systematic risk. The official sector will always have to step in to help.... `Shadow banks will always exist. Their omnipresence -- through arbitrage, innovation and gains from specialization -- is a standard feature of all advanced financial systems.

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