Today's entry comes from Mark Thoma, who writes in a guest-blog at the Washington Post:
The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.
I don't want to be too hard on Prof. Thoma: his second sentence is correct, assuming the definition of "shadow banking system" encompasses Subprime Mortgage-To-Go (which offers drive-thru!). But unlike Long-Term Capital Management's meltdown in 1998, the systemic breakdowns we have been experiencing over the past 18 months have been caused by problems at the major banks (even the former investment-only banks which weren't regulated by the Fed or FDIC cannot be called part of the "shadow banking system"), AIG (regulated by the state insurance commissioners, even if they'd rather you didn't remember) and let's not forget Fannie and Freddie, which had their own regulator. (And the most acute phase of the crisis was touched off by the Reserve Primary Fund's "breaking the buck," even though money market funds are among the most stringently regulated entities on earth.) Only when the products of Subprime Mortgage-To-Go were thoroughly integrated into the activities of these heavily regulated institutions (and sometimes even acquired in full by them; just ask Wachovia and Merrill) was the stage set for the financial crisis. By contrast, though numerous hedge funds have failed, some people are beginning to look longingly at the sector as one in which even major players can fail without touching off a systemic meltdown.
This isn't necessarily an argument against extending regulation to the "shadow banking sector," but we should be on guard against any tendency to assume that the job has been done when a previously unregulated activity now has a regulation applied to it. In reality, that is when the work begins.
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