A major financial crisis can have unexpected and long-lasting effects. A November 19th report from the Center for Financial Stability highlights the massive downsizing of the so-called shadow banking sector in the U.S. since the 2008 financial crisis, and points out the serious consequences of a lack of this kind of “market financing” to the overall economy.

One key finding of the CFS report is that access to market finance has shrunk by 45% in real terms since 2008, the largest decline in over four decades.

Shadow Banking

Understanding shadow banking

Author Lawrence Goodman begins with an explanation of shadow banking and why it’s important. “The tainted image of shadow banking along with the nefarious sounding name is a disservice to the U.S. economy. Shadow banking to a substantial degree is simply “market finance.” In fact, many cite access to “market finance” as essential to provide the U.S. financial system with strength and flexibility. This market or non-bank based finance provides a stark contrast with the more rigid and heavily bank dominated system in Europe.”

Market financing is a two-edged sword, but essential for growth

Goodman is forthright in saying that the shadow banking sector is a two-edged sword in that it can fuel bubbles in strong economic cycles as well as provide capital to keep small and mid-size businesses alive in recessionary cycles. It is widely acknowledged that greedy shadow bankers have played a central role in enabling a number of financial crises over the last few decades, including the recent one.

He notes: “In fact, the proliferation of market finance reached unforeseen highs prior to the recent crisis and facilitated numerous excesses.”

However, Goodman continues to say that CFS data make it clear that market finance in the economy is overdone and detrimental to future economic growth. He points out: “The shadow banking system is under severe strain. Of course, market finance grew too large in advance of the recent financial crisis and the reduction in the sector provides a healthier base for the US economy and markets. Yet, the deterioration is unprecedented (see Figure 2).”

Shadow Banking

Even worse, U.S. market finance doesn’t seem to be stabilizing, with a series of successive drops from the beginning of the crisis to the latest monetary data available through October 2014. In fact, last month was the 79th consecutive month of decline in amounts financed through the shadow banking system.

Shadow Banking