How Shadow Banks Rule the World

Nov. 18, 2012— -- Beyond the banking world, a parallel universe of shadow banks has grown in the form of hedge funds and money market funds. They're outside the reach of conventional financial regulation, prompting authorities to plan introducing new rules to prevent the obscure sector from triggering a new financial crisis. But in doing so they risk drying up an important source of funding to banks and firms.

In the financial world, there is a narrow divide between heaven and hell. Frenchman Loïc Féry realized this when he was 33. He was a rising star in the banking world, managing the trade in complex loan packages for an investment bank. According to his business card, he was the bank's "global head of credit markets." But then one of his employees gambled away about €250 million ($317 million), and suddenly Féry was without a job.

That was in 2007. A number of investment bankers experienced a similarly precipitous fall in the turbulent years of the financial crisis. But, like Féry, many reappeared before long and became more successful than ever, in the world of the so-called shadow banks. These are companies that engage in business similar to that of ordinary banks, but without being subject to the same strict regulation.

Féry launched a hedge fund in London. These notorious investment firms collect money from customers and speculate with a wide range of securities. Today Féry makes the kinds of investments that are too risky for his former colleagues. He lends the money of his customers to companies whose creditworthiness isn't good enough to qualify for loans from ordinary banks, and he also buys especially risky loan packages from lenders. As a result, he is able to achieve double-digit returns in the midst of a crisis.

But the Frenchman, who has become so successful that he was able to buy a first-division football club, FC Lorient, insists that companies like his make "a positive contribution to the real economy," because they manage risks professionally.

Growing Concern About Lack of Regulation

But banks, regulators, politicians and economists are worried about the parallel universe that has developed beyond the major banks. Until the 2007 financial crisis, shadow banks grew at a pace similar to that of ordinary financial institutions. Hedge funds, special-purpose entities and money market funds benefited from the low interest rates offered by central banks. Banks increasingly used outside companies to handle all the deals that were too risky for them, so that they wouldn't appear on their books. In this manner, shadow banks and regular banks collaborated to build a castle in the air made up of loans.

Within a few years, the volume of financial transactions in the world of shadow banks grew from $27 trillion to $60 trillion today. Now regulators finally want to clamp down and set up a regulatory framework that has so far been conspicuous by its absence for this sector.

After the financial crisis of 2008, German Chancellor Angela Merkel, of the center-right Christian Democratic Union (CDU), said that there could be no "blind spots" on the map of financial market regulation. But while more and more laws were passed to control banks, regulation of the shadow banks is only just beginning.