Shadow banking, the lending that takes place outside of the banking system, is growing rapidly. It poses a major threat to the world financial system.
A decade ago, America's banks were in ruins — Lehman, Washington Mutual, IndyMac and Bear Stearns gone, Citi and Bank of America wards of the state. After the crisis, the goal was to make banks safer. But the potential for a sudden, 2008-like seizure in global credit markets increasingly lies beyond traditional banking. In 2008, government officials knew which institutions to rescue to avoid global paralysis. Next time, they may be chasing shadows.
Many commentators blamed the 2008 financial crisis on complex financial instruments. But the locus was traditional banks, commercial and investment. Firms such as Citibank and Lehman had kept tens of billions of dollars of mortgage-related debt and related derivative instruments on their books, and investors feared that future losses would force the institutions into default.
And the ultimate cause of the crisis wasn't complex: a massive increase in debt, with too little capital behind it. By 2008, bank capital levels had sunk to an all-time low. Since then, thanks to tougher rules, capital ratios have risen.
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Nicole Gelinas is a senior fellow at the Manhattan Institute and contributing editor at City Journal. Follow her on Twitter here.
This piece originally appeared in Investor's Business Daily