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SHADOW BANKING 

ratio of :, with the numbers representing the total money invested compared to
the money the investor has committed to the deal.
In , bank supervisors established the first formal minimum capital standards,
which mandated that capital—the amount by which assets exceed debt and other lia-
bilities—should be at least  of assets for most banks. Capital, in general, reflects
the value of shareholders’ investment in the bank, which bears the first risk of any po-
tential losses.
By comparison, Wall Street investment banks could employ far greater leverage,
unhindered by oversight of their safety and soundness or by capital requirements
outside of their broker-dealer subsidiaries, which were subject to a net capital rule.
The main shadow banking participants—the money market funds and the invest-
ment banks that sponsored many of them—were not subject to the same supervision
as banks and thrifts. The money in the shadow banking markets came not from fed-
erally insured depositors but principally from investors (in the case of money market
funds) or commercial paper and repo markets (in the case of investment banks).
Both money market funds and securities firms were regulated by the Securities and
Exchange Commission. But the SEC, created in , was supposed to supervise the
securities markets to protect investors. It was charged with ensuring that issuers of
securities disclosed sufficient information for investors, and it required firms that
bought, sold, and brokered transactions in securities to comply with procedural re-
strictions such as keeping customers’ funds in separate accounts. Historically, the
SEC did not focus on the safety and soundness of securities firms, although it did im-
pose capital requirements on broker-dealers designed to protect their clients.
Meanwhile, since deposit insurance did not cover such instruments as money
market mutual funds, the government was not on the hook. There was little concern
about a run. In theory, the investors had knowingly risked their money. If an invest-
ment lost value, it lost value. If a firm failed, it failed. As a result, money market funds
had no capital or leverage standards. “There was no regulation,” former Fed chair-
man Paul Volcker told the Financial Crisis Inquiry Commission. “It was kind of a

free ride.” The funds had to follow only regulations restricting the type of securities
in which they could invest, the duration of those securities, and the diversification of
their portfolios. These requirements were supposed to ensure that investors’ shares
would not diminish in value and would be available anytime—important reassur-
ances, but not the same as FDIC insurance. The only protection against losses was
the implicit guarantee of sponsors like Merrill Lynch with reputations to protect.
Increasingly, the traditional world of banks and thrifts was ill-equipped to keep
up with the parallel world of the Wall Street firms. The new shadow banks had few
constraints on raising and investing money. Commercial banks were at a disadvan-
tage and in danger of losing their dominant position. Their bind was labeled “disin-
termediation,” and many critics of the financial regulatory system concluded that
policy makers, all the way back to the Depression, had trapped depository institu-
tions in this unprofitable straitjacket not only by capping the interest rates they could
pay depositors and imposing capital requirements but also by preventing the institu-
tions from competing against the investment banks (and their money market mutual