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SHADOW BANKING
squeeze caused by inflation, but it effectively transferred the risk of rising interest
rates to borrowers.
Then, beginning in , the Federal Reserve accommodated a series of requests
from the banks to undertake activities forbidden under Glass-Steagall and its modifi-
cations. The new rules permitted nonbank subsidiaries of bank holding companies to
engage in “bank-ineligible” activities, including selling or holding certain kinds of se-
curities that were not permissible for national banks to invest in or underwrite. At
first, the Fed strictly limited these bank-ineligible securities activities to no more
than of the assets or revenue of any subsidiary. Over time, however, the Fed re-
laxed these restrictions. By , bank-ineligible securities could represent up to
of assets or revenues of a securities subsidiary, and the Fed also weakened or elimi-
nated other firewalls between traditional banking subsidiaries and the new securities
subsidiaries of bank holding companies.
Meanwhile, the OCC, the regulator of banks with national charters, was expand-
ing the permissible activities of national banks to include those that were “function-
ally equivalent to, or a logical outgrowth of, a recognized bank power.” Among
these new activities were underwriting as well as trading bets and hedges, known as
derivatives, on the prices of certain assets. Between and , the OCC broad-
ened the derivatives in which banks might deal to include those related to debt secu-
rities (), interest and currency exchange rates (), stock indices (),
precious metals such as gold and silver (), and equity stocks ().
Fed Chairman Greenspan and many other regulators and legislators supported
and encouraged this shift toward deregulated financial markets. They argued that fi-
nancial institutions had strong incentives to protect their shareholders and would
therefore regulate themselves through improved risk management. Likewise, finan-
cial markets would exert strong and effective discipline through analysts, credit rat-
ing agencies, and investors. Greenspan argued that the urgent question about
government regulation was whether it strengthened or weakened private regulation.
Testifying before Congress in , he framed the issue this way: financial “modern-
ization” was needed to “remove outdated restrictions that serve no useful purpose,
that decrease economic efficiency, and that . . . limit choices and options for the con-
sumer of financial services.” Removing the barriers “would permit banking organiza-
tions to compete more effectively in their natural markets. The result would be a
more efficient financial system providing better services to the public.”
During the s and early s, banks and thrifts expanded into higher-risk
loans with higher interest payments. They made loans to oil and gas producers, fi-
nanced leveraged buyouts of corporations, and funded developers of residential and
commercial real estate. The largest commercial banks advanced money to companies
and governments in “emerging markets,” such as countries in Asia and Latin Amer-
ica. Those markets offered potentially higher profits, but were much riskier than the
banks’ traditional lending. The consequences appeared almost immediately—espe-
cially in the real estate markets, with a bubble and massive overbuilding in residential
and commercial sectors in certain regions. For example, house prices rose per
year in Texas from to . In California, prices rose annually from 
