What Is Shadow Banking…and Why Does It Matter to You?

You may wonder what financial experts mean when they mention the shadow banking system. The term might remind you of expressions like “dark web” or “black market,” but there’s nothing illicit about shadow banks. Instead, think about what a traditional bank does—collects deposits and makes loans. Shadow banks, also called nonbank financial institutions (NBFIs), don’t have bank charters and make loans without collecting deposits.

An array of entities fall under this umbrella. The sketchiest are payday lenders and loan sharks. More reputable ones are hedge funds, private equity funds, business development corporations, mortgage lenders, real estate investment trusts (REITs) and fintech firms that facilitate services such as buy now/pay later.

Most shadow-bank lending is to businesses, but NBFIs do lend huge sums to individuals. Why borrow from a shadow bank? They are far less regulated than institutions with banking charters and can take on greater risk.

Example: Say you’ve started a company that aims to buy commercial real estate to rent out as office space. Work-from-home has decimated that sector. If you seek a big loan from a traditional bank, it likely will be denied. Even if it isn’t, government regulators would frown on such an irresponsible loan. But an NBFI might lend you the funds if you’ll pay a high interest rate…and no regulators scrutinize NBFI decisions.

The problem: Some things about shadow banking warrant concern…

Lack of regulation: NBFIs are not required to maintain minimum levels of liquidity or cash. They don’t need to have loan-loss reserves. They can have outlandish debt-to-equity ratios. They can charge outrageous fees and interest rates. And if they face a sudden emergency, they can’t borrow from the Fed the way banks can.

Sheer size: NBFIs account for nearly 30% of lending in the US, some $850 billion. That’s a lot of unregulated debt.

Interconnected economy: NBFIs are not safely separate from the banking system. Many rely on banks for funding. When banks feel the pinch, they’re likely to cut off funding for NBFIs.

To protect your money. Stick to the regulated side of banking when you must borrow. Understand lending terms, and don’t be tempted by offers of quick credit.