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The Shadow Banking System is a Polite Term For Unreported, Unregulated Banking Practices Which Allow the Elite Bankers Freedom to Run the World.

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The debt-creating, dollar-printing activities of the Federal Reserve Banks and the fractional reserve banking practices of the retail banks are not enough for the elite.

America has also suffered the consequences of a new form of banking.

Sometimes called the shadow baking system, this refers to the institutions that construct a vast number of unregulated and unreported structured deals that are contracted between banks themselves and between banks and investors.

These deals, or products, are highly theoretical and derivative in nature and they are all aimed at spreading risk and maximizing profits for everyone involved.

Interestingly enough, billionaire investor Warren Buffett has described derivatives as ‘weapons of mass destruction”.

So we were warned. The shadow banking system has come under scrutiny since the events of 2008.

The system includes everything from junk bonds to futures contracts, but no one knows how widespread this type of banking is, what kind of deals it includes (too many to count presumably), or how much the sum of such deals are worth.

What is known, however, is that one such product was responsible for the mortgage debt crisis, Wall Street crash, and resultant recession that struck in 2008, and for the record there is no sign this crisis is over or that the ultimate parties holding the babies have been identified.

At the root of the trouble were packaged products called credit default swaps (CDSs).

Invented in 1995 by a 34 year old English Cambridge graduate, Blythe Masters, who was working for JP Morgan in New York, these were essentially insurance policies that banks took out in case of mass default on mortgage loans.

Except CDSs could not be called insurance because the insurance industry is regulated.

Too bad they were not regulated because when there were mass defaults on mortgage loans, insurance could not pay out because the parties that had carried the risk did not have the cash to pay the banks that called in their claims.

Needless to say, the banks had been free and easy in granting loans because they thought their risk was covered.

The defaults were in countless billions and in most cases the CDS deals were so complicated it is not yet clear who bears the ultimate responsibility for the various loan default packages.

It is a complete mess, and no amount of political smooth talking or Fed rationales or promises to cover the debt can conceal this fact.

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Shadow Banking System in the Open

One positive result of the 2008 crisis is shadow banking is now firmly in the spotlight.

The first thing evident when you examine common practices in the shadows, is the products are invariably extremely complicated.

They seem to make sense only to people who were honors graduates from schools like MIT and Cambridge, and that should send out warning signals. Anything that complicated can be abused.

The formal definition of the shadow banking system (or shadow financial system as it is sometimes called) is it includes non-bank financial institutions (such as Bear Stearns and Lehman Brothers) that, like banks, borrow short, and in liquid form, and lend or invest long in less liquid assets.

They are able to do this via the use of credit derivative instruments which allow them to evade normal banking regulations, e.g., those related to specifying ratios of capital reserves to debt.

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New Shadow Banking Regulation

The good news is the main perpetrators, big brokerages like Goldman Sachs, Lehman Brothers, Morgan Stanley and Merrill Lynch are all under siege now that regulators are threatening to crackdown on their shadow banking practices.

Whether they will actually do so remains to be seen.

It is worth noting that Enron, which collapsed in bankruptcy and chaos, was acting as a shadow banking institution rather than as an energy business.

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How Big is the U.S. Shadow Banking System?

Big players like these, with more than $10 trillion in paper assets by 2007, have a lot to lose from stricter regulations.

According to the Federal Reserve Bank, the sector is roughly the same size as the traditional banking system.

While this system became a huge and vital source of money to fuel the ever-ballooning U.S. economy, the 2008 montage crisis and ensuing credit crunch exposed a major flaw in the edifice of shadow banking.

Unlike regulated banks, which can borrow practically endlessly in times of financial stress, the shadow banks do not have reliable access to short-term borrowing facilities.

However, the real problem is will the banking elite allow their little secrets to be exposed?

And if so, how will they replace them? Because one thing is for sure, the banking elite is not going away.

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