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SHADOW BANKING 

able them to pay off their debts should there be another shock. These moves reas-
sured investors that commercial paper was a safe investment.
In the s, the commercial paper market jumped more than sevenfold. Then in
the s, it grew almost fourfold. Among the largest buyers of commercial paper
were the money market mutual funds. It seemed a win-win-win deal: the mutual
funds could earn a solid return, stable companies could borrow more cheaply, and
Wall Street firms could earn fees for putting the deals together. By , commercial
paper had risen to . trillion from less than  billion in . 
The second major shadow banking market that grew significantly was the market
for repos, or repurchase agreements. Like commercial paper, repos have a long his-
tory, but they proliferated quickly in the s. Wall Street securities dealers often
sold Treasury bonds with their relatively low returns to banks and other conservative
investors, while then investing the cash proceeds of these sales in securities that paid
higher interest rates. The dealers agreed to repurchase the Treasuries—often within a
day—at a slightly higher price than that for which they sold them. This repo transac-
tion—in essence a loan—made it inexpensive and convenient for Wall Street firms to
borrow. Because these deals were essentially collateralized loans, the securities deal-
ers borrowed nearly the full value of the collateral, minus a small “haircut.” Like com-
mercial paper, repos were renewed, or “rolled over,” frequently. For that reason, both
forms of borrowing could be considered “hot money”—because lenders could
quickly move in and out of these investments in search of the highest returns, they
could be a risky source of funding.
The repo market, too, had vulnerabilities, but it, too, had emerged from an early
crisis stronger than ever. In , two major borrowers, the securities firms Drysdale
and Lombard-Wall, defaulted on their repo obligations, creating large losses for
lenders. In the ensuing fallout, the Federal Reserve acted as lender of last resort to
support a shadow banking market. The Fed loosened the terms on which it lent
Treasuries to securities firms, leading to a -fold increase in its securities lending.
Following this episode, most repo participants switched to a tri-party arrangement in
which a large clearing bank acted as intermediary between borrower and lender, es-

sentially protecting the collateral and the funds by putting them in escrow. This
mechanism would have severe consequences in  and . In the s, how-
ever, these new procedures stabilized the repo market.
The new parallel banking system—with commercial paper and repo providing
cheaper financing, and money market funds providing better returns for consumers
and institutional investors—had a crucial catch: its popularity came at the expense of
the banks and thrifts. Some regulators viewed this development with growing alarm.
According to Alan Blinder, the vice chairman of the Federal Reserve from  to
, “We were concerned as bank regulators with the eroding competitive position
of banks, which of course would threaten ultimately their safety and soundness, due
to the competition they were getting from a variety of nonbanks—and these were
mainly Wall Street firms, that were taking deposits from them, and getting into the
loan business to some extent. So, yeah, it was a concern; you could see a downward
trend in the share of banking assets to financial assets.” 