In a speech to the CASS Business School the Chairman of the Financial Services Authority (FSA), Lord Turner, set out how the ‘shadow banking’ sector contributed to the financial crisis, the risks it still poses to financial stability and the importance of a sufficiently comprehensive and radical policy response. He highlighted that the 2007-08 financial crisis was not one simply caused by high street banks but one where shadow banking activities played a major role.  He described how the shadow banking sector is not simply a standalone system running parallel to the regular banking system but is linked to the banking system in complex and difficult to discern ways that can make the whole system less stable. He stressed that major reforms had been put in place in the wake of the crisis for ‘normal’ banks including increased capital and liquidity requirements and better supervision, but said there had yet to be a similar response to the ‘shadow’ sector and that this needed to be addressed urgently.

Lord Turner described shadow banking as covering multiple specific institutions and activities including securitised lending, hedge funds active in credit markets, investment bank trading of credit securities, the issuance of asset backed commercial paper and the ‘repo’ market. He set out how money could move through the system in long and complex chains which in combination performed the same role as banks, which involved the same risks, but which fell outside the framework of controls with which regulators seek to make the banking system safe.  Estimates of the size of the shadow banking system were, Lord Turner stressed, very uncertain because of the sheer complexity of the system, but some researchers have suggested figures of around $20tn for shadow banking activity in the US in 2007 and around $13tn in Europe.  

He argued that some of the particular forms which shadow banking took in the pre-crisis period had declined in importance, but that the underlying factors which drove shadow banking development were still present, and unless checked by appropriate regulation, would produce instability in future. These underlying factors include: (i) the desire of investors to hold more liquid short term assets than the private financial system can safely provide; (ii) the tendency of financial innovation continuously to create additional complexity and opacity, and to make the system more interconnected and vulnerable to shocks; and (iii) the increasing role of short term secured financed – such as the repo markets, which when combined with mark-to-market accounting and continuous revaluation could “hardwire” potential instability into the financial system.