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KEITH HENNESSEY, DOUGLAS HOLTZ-EAKIN, AND BILL THOMAS 

• International and domestic regulators encouraged arbitrage toward lower capi-
tal standards;
• Some investors used these securities to concentrate rather than diversify risk;
and
• Others used synthetic CDOs to amplify their housing bets.

The dangerous imprecision of the term “shadow banking”

Part II of the majority’s report begins with an extensive discussion of the failures of
the “shadow banking system,” which it defines as a “financial institutions and activi-
ties that in some respects parallel banking activities but are subject to less regulation
than commercial banks.” The majority’s report suggests that the shadow banking sys-
tem was a cause of the financial crisis.
“Shadow banking” is a term used to represent a collection of different financial in-
stitutions, instruments, and issues within the financial system. Indeed, “shadow
banking” can refer to any financial activity that transforms short-term borrowing
into long-term lending without a government backstop. This term can therefore in-
clude financial instruments and institutions as diverse as:

• The tri-party repo market;
• Structured Investment Vehicles and other off-balance-sheet entities used to in-
crease leverage;
• Fannie Mae and Freddie Mac;
• Credit default swaps; and
• Hedge funds, monoline insurers, commercial paper, money market mutual
funds, and investment banks.

As discussed in other parts of this paper, some of these items were important
causes of the crisis. No matter what their individual roles in causing or contributing
to the crisis, however, they are undoubtedly different. It is a mistake to group these is-
sues and problems together. Each should be considered on its merits, rather than
painting a poorly defined swath of the financial sector with a common brush of “too
little regulation.”

BIG BANK BETS AND WHY BANKS FAILED
The story so far involves significant lost housing wealth and diminished values of se-
curities financing those homes. Yet even larger past wealth losses did not bring the
global financial system to its knees. The key differences in this case were leverage and
risk concentration. Highly correlated housing risk was concentrated in large and
highly leveraged financial institutions in the United States and much of Europe. This
leverage magnified the effect of a housing loss on a financial institution’s capital re-
serve, and the concentration meant these losses occurred in parallel.