The Shadow Banking System and the Financial Crisis:A securities production function view

There is no doubt that the shadow banking system played an important role in the global financial crisis. What is in question is whether it played a causal or merely amplifying role. This paper argues in favour of the latter. Focusing specially on the process of the production of CDOs through the shadow banking system, we argue that it was non-bank financial institutions, most notably hedge funds but also pension and mutual funds and insurance companies, which had causal primacy in the financial crisis. The insatiable demand for assets exercised by these institutions compelled the shadow banks to accelerate the production of CDOs to a scale of sufficient proportions as to be able to cause the money and interbank markets to seize up in August 2007. The conclusion that follows from this argument is that tight regulation of the shadow banking system will not suffice to prevent a future financial crisis. For this objective to be met banking regulation needs to be accompanied by wider policy measures aimed at reducing the pressures on the banking system to create the type of toxic securities that triggered the last financial crisis.