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SHADOW BANKING 

A basic understanding of these four developments will bring the reader up to
speed in grasping where matters stood for the financial system in the year , at
the dawn of a decade of promise and peril.

COMMERCIAL PAPER AND REPOS:
“UNFETTERED MARKETS”
For most of the th century, banks and thrifts accepted deposits and loaned that
money to home buyers or businesses. Before the Depression, these institutions were
vulnerable to runs, when reports or merely rumors that a bank was in trouble
spurred depositors to demand their cash. If the run was widespread, the bank might
not have enough cash on hand to meet depositors’ demands: runs were common be-
fore the Civil War and then occurred in , , , , , and . To

stabilize financial markets, Congress created the Federal Reserve System in ,
which acted as the lender of last resort to banks.
But the creation of the Fed was not enough to avert bank runs and sharp contrac-
tions in the financial markets in the s and s. So in  Congress passed the
Glass-Steagall Act, which, among other changes, established the Federal Deposit In-
surance Corporation. The FDIC insured bank deposits up to ,—an amount that
covered the vast majority of deposits at the time; that limit would climb to , by
, where it stayed until it was raised to , during the crisis in October .
Depositors no longer needed to worry about being first in line at a troubled bank’s
door. And if banks were short of cash, they could now borrow from the Federal Re-
serve, even when they could borrow nowhere else. The Fed, acting as lender of last re-
sort, would ensure that banks would not fail simply from a lack of liquidity.
With these backstops in place, Congress restricted banks’ activities to discourage
them from taking excessive risks, another move intended to help prevent bank fail-
ures, with taxpayer dollars now at risk. Furthermore, Congress let the Federal Reserve
cap interest rates that banks and thrifts—also known as savings and loans, or S&Ls—
could pay depositors. This rule, known as Regulation Q, was also intended to keep in-
stitutions safe by ensuring that competition for deposits did not get out of hand. 
The system was stable as long as interest rates remained relatively steady, which
they did during the first two decades after World War II. Beginning in the late-s,
however, inflation started to increase, pushing up interest rates. For example, the
rates that banks paid other banks for overnight loans had rarely exceeded  in the
decades before , when it reached . However, thanks to Regulation Q, banks
and thrifts were stuck offering roughly less than  on most deposits. Clearly, this
was an untenable bind for the depository institutions, which could not compete on
the most basic level of the interest rate offered on a deposit.
Compete with whom? In the s, Merrill Lynch, Fidelity, Vanguard, and others
persuaded consumers and businesses to abandon banks and thrifts for higher returns.
These firms—eager to find new businesses, particularly after the Securities and Ex-
change Commission (SEC) abolished fixed commissions on stock trades in —
created money market mutual funds that invested these depositors’ money in