In-Depth: The Credit Crunch Reflects Collapse of a “Shadow Banking System”

Julie L. Stackhouse , William R. Emmons

Many consumers and business owners are wondering: Have banks stopped lending?

The answer depends on the status of financial institutions. Most banks, especially in the Eighth District, remain in generally sound financial condition and continue the economic necessity of lending to customers with good credit quality. However, some banks are facing severe financial distress, creating a need to preserve capital—which gives the appearance of a credit crunch. To improve their regulatory capital-to-asset ratios, some banks are reducing their total assets on the balance sheet by reducing the amount of loans outstanding. Some banks are improving ratios by raising more capital either privately or through recent government programs if eligibility requirements are met.

In large part, the reduction in credit availability can be attributed to the partial collapse of the “shadow banking system.”

In its simplest sense, the shadow banking system represents credit instruments that exist outside of the traditional commercial banking system, especially those related to consumer credit. Older parts of the shadow system include financial assets issued through government-supported institutions, such as Fannie Mae and Freddie Mac.

More interesting is the growth in assets in the nongovernment-supported and nongovernment-insured sectors. As shown in the chart, these so-called private label assets grew at a three-fold rate over the past eight years. Some of these financial instruments, including the vast majority of the subprime mortgage market, were high-risk in nature as well. The securities created from these assets were often complex, with poor transparency and sometimes questionable suitability for unsophisticated customers. The intermediaries issuing and trading the securities included nationally and internationally active investment banks, hedge funds and some insurance companies. Most of these entities were not required to be supervised by banking regulators.

It is this part of the lending market that has collapsed. According to Federal Reserve data, total household loans outstanding (mortgages and other consumer credit) decreased during the six months ending Sept. 30, 2008. This marked the first six-month decline since at least 1952, when comprehensive data first became available.

To the extent that the underpinnings of the shadow banking system were unsound, we should not expect that system to return anytime soon—especially the market for securitized subprime mortgages. For other segments, return of the securitized market will depend on investor confidence and a move toward increased transparency for investors.

fig1

Subscribe

Keep up with what’s new and noteworthy at the St. Louis Fed. Sign up now to have this free monthly e-newsletter emailed to you.

Subscription Options


Additional Fed Publications

Fed in Print: An index of the economic research conducted by the Fed.