Before the financial crisis the non-bank institutions such as: hedge funds, inve

Question

Before the financial crisis the non-bank institutions such as: hedge funds, investment banks and money market mutual funds, had become an increasingly important means of channeling money from lenders to borrowers. These non-bank financial institutions were labeled as “shadow banking system”

a. In what ways does the shadow banking system differ from the commercial banking system? Explain

b. Why have runs on commercial banks become rare, while several shadow banking firms experienced runs during the financial crisis?

Explanation / Answer

a. A Shadow bank looks like a bank, acts like a bank, but it’s not really a bank. Shadow banks mobilize funds from the money markets and use those funds to buy assets with long term maturities. Since these are not controlled or regulated by the Federal Reserve, they are in the shadows. Shadow banks differ from commercial banks in that they do not accept deposits and do not lend to households. They are involved in the buying of mortgages by bundling large numbers of them together as bonds. These are called as mortgage-backed securities. They carry high interest rates with comparable default risk and reselling them to investors.

Bank runs happen when investors attempt to withdraw all of their money before the bank fails. It is because of loss of trust and insecurity these runs happen. But, now, because commercial banks insure depositors money with the Federal Deposit Insurance Corporation (FDIC) that bank runs have become a rare phenomenon. However, the FDIC does not cover shadow banking industry because their short-term borrowing is not in the form of deposits.

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