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SHADOW BANKING

CONTENTS

Commercial paper and repos: “Unfettered markets”............................................
The savings and loan crisis: “They put a lot of
pressure on their regulators” ............................................................................

The financial crisis of  and  was not a single event but a series of crises that
rippled through the financial system and, ultimately, the economy. Distress in one
area of the financial markets led to failures in other areas by way of interconnections
and vulnerabilities that bankers, government officials, and others had missed or dis-
missed. When subprime and other risky mortgages—issued during a housing bubble
that many experts failed to identify, and whose consequences were not understood—
began to default at unexpected rates, a once-obscure market for complex investment
securities backed by those mortgages abruptly failed. When the contagion spread, in-
vestors panicked—and the danger inherent in the whole system became manifest. Fi-
nancial markets teetered on the edge, and brand-name financial institutions were left
bankrupt or dependent on the taxpayers for survival.
Federal Reserve Chairman Ben Bernanke now acknowledges that he missed the
systemic risks. “Prospective subprime losses were clearly not large enough on their
own to account for the magnitude of the crisis,” Bernanke told the Commission.
“Rather, the system’s vulnerabilities, together with gaps in the government’s crisis-re-
sponse toolkit, were the principal explanations of why the crisis was so severe and
had such devastating effects on the broader economy.” 
This part of our report explores the origins of risks as they developed in the finan-
cial system over recent decades. It is a fascinating story with profound conse-
quences—a complex history that could yield its own report. Instead, we focus on four
key developments that helped shape the events that shook our financial markets and
economy. Detailed books could be written about each of them; we stick to the essen-
tials for understanding our specific concern, which is the recent crisis.
First, we describe the phenomenal growth of the shadow banking system—the
investment banks, most prominently, but also other financial institutions—that
freely operated in capital markets beyond the reach of the regulatory apparatus that
had been put in place in the wake of the crash of  and the Great Depression.
