The proliferation of the shadow banking system has been identified as one of the causes of the financial crisis, and hedge funds often share the blame. On Nov. 18, 2012, the Financial Stability Board announced that the shadow banking system had grown to $67 trillion. The FSB provides recommendations to strengthen oversight and regulation of shadow banking and defines the system broadly as non-bank credit intermediation. While some hedge funds are involved in shadow banking activities, the terms "shadow bank" and "hedge fund" cannot be considered synonyms.
Naming the System
The term "shadow banking system" was originally coined by Paul McCulley of PIMCO in an article written in September 2007. He was commenting on topics discussed days earlier at the Kansas City Federal Reserve Bank's Jackson Hole (Wyoming) 2007 Symposium, which was focused on “Housing, Housing Finance and Monetary Policy.” McCulley wrote about early concerns of systemic risk, stating, “In the current circumstance, it’s called a run on what I’ve dubbed the ‘shadow banking system’ – the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.”
The so-called shadow banking system had been growing for decades before being given a name in 2007. It is very complex, but since the financial crisis that began in 2008, progress has been made in efforts to define it. According to the FSB, “Only entities and activities involved in extending credit (either directly or as part of a chain of credit intermediation) or involved in facilitating its intermediation are included” in the broad definition of shadow banking. Pure equity trading and foreign currency transactions would be excluded, while trading of credit-related financial instruments, such as bonds and structured/hybrid financial products, would be included.
Criteria for Shadow Banking
The FSB also offers a narrower definition of the shadow banking system. In addition to being a system of credit intermediation, it involves entities and activities outside the regular banking system and raises concerns over systemic risk and/or regulatory arbitrage.
The second criteria “implies that credit intermediation takes place in an environment where prudential regulatory standards and supervisory oversight are either not applied or are applied to a materially lesser or different degree than is the case for regular banks engaged in similar activities.”
Systemic risk refers to how the actions of one entity can potentially impact the broader financial system. Under the Dodd–Frank Wall Street Reform and Consumer Protection Act , institutions with over $50 billion in assets are deemed "systemically important financial institutions."
Regulatory arbitrage refers to finding ways around regulations that are designed to protect and stabilize the financial system.
Many Types of Hedge Funds
There are many types of hedge funds, each following different strategies and investing in different types of securities. Some simply trade equity securities and cannot be considered part of the shadow banking system. There is no broad consensus on whether any type of hedge fund fits all of the criteria of a shadow bank as outlined by the FSB. The Alternative Investment Management Association makes a strong case that virtually all hedge funds do not. AIMA has identified several sub-classes of hedge funds that can be considered “credit hedge funds” as often mentioned in descriptions of the shadow banking system. AIMA estimates that these credit hedge funds constitute approximately $630 billion and comprise less than a third of the global hedge fund industry. They estimate that only two very large hedge fund firms qualify as systemically important financial institutions, “with the largest of these hedge fund advisers managing assets equal to approximately 3% of the entire hedge fund industry.”
Kathryn Christopher has been writing about investments for more than 20 years. Her work has appeared in the "Journal of Alternative Investments" and numerous other academic and industry publications. She works at Wiggin Financial Planning, teaches for UMASSOnline from South Florida, and holds a PhD in finance from the University of Massachusetts.