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Chapter 25: Problem 4

What is the "shadow banking system"? Why were the financial firms of the shadow banking system more vulnerable than commercial banks to bank runs?

Short Answer

Expert verified
The shadow banking system is comprised of financial intermediaries providing services similar to traditional banks but operates outside standard banking regulations. They are more susceptible to bank runs due to their heavy reliance on short-term wholesale funding, lack of access to central bank funding or financial safety nets, and typically high leverages.

Step by step solution

01

Understanding the Shadow Banking System

The shadow banking system is a term for the collection of financial intermediaries that provide services similar to traditional commercial banks but outside normal banking regulations. These can include entities such as hedge funds, money market funds and investment banks. They're called 'shadow banks' because they don't have banking licenses, they don't take deposits, and their operations are not subject to regulatory oversight.
02

Recognizing the Vulnerabilities

Shadow banks are more vulnerable to bank runs because of several reasons. First, they rely heavily on short term wholesale funding which can be withdrawn quickly. Secondly, they do not have access to central bank funding or safety nets such as deposit insurance and emergency funding that are available to regulated banks. Lastly, they are often highly leveraged, meaning they have a high proportion of debt relative to their equity, which can make them more vulnerable to shocks.

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