At midnight, several hours before Vikram Pandit resigned, Bloomberg ran a story about a speech in which Pandit criticized federal regulators for not addressing the shadow banking system. I have previously expressed some views on shadow banking. I told Bloomberg about the irony of the CEO of a global investment bank calling for more regulation of a system in which investment banks not only actively participate but, moreover, serve as central hubs.
Events in Mr. Pandit's career today overtook the story.
But it is useful to remember the key role that shadow banking markets (asset-backed securities, asset-backed commercial paper, money-market mutual funds, repos, credit derivatives) played in the financial crisis and in Citi's operations. These markets served many of the same economic functions as traditional depository banks (providing credit and theoretically safe and liquid investments). The crisis revealed that these markets suffered the same types of crises as banks (shadow bank runs). The federal bailouts then deployed the same conceptual tools that governments historically used to address banking crises (government as lender-of-last-resort and effective deposit insurance). Now the question is whether these markets should be regulated to reduce moral hazard, just like banks are.
Pandit's abrupt resignation may have deprived us of having a clearer sense of what shadow banking is and the risks it poses. It is not a rhetorical device to hint at some unspecified set of institutions that sit outside regulation. Shadow banking is actually very much about investment banks and regulated entities at play in less regulated markets.
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