The discussion over at the Atlantic has evolved so now the argument is that regulators knew about the “shadow banking system” and, thus, its failures are the regulators fault. Of course, there’s some truth to this view — but it also implies that the shadow banking system should be regulated.
When I hear the term “shadow banking system” I don’t think of “shadow” as meaning “in the shadows” or “hiding”, I think of it as a term like “shadow government” in the UK. In other words, the “shadow banking system” is just a parallel banking system. It’s public; everybody who cares to know knows about it, but the average person pays it no attention because it doesn’t appear to have any effect on their lives.
The problem with the shadow banking system is that it’s every bit as unstable as a traditional banking system, without any of the safeguards in terms of capital requirements and a lender of last resort.
In other words, the problem with the shadow banking system is that it wasn’t regulated as a banking system. It’s certainly fair to argue that the fact that it’s not regulated as a banking system is the fault of the regulators, but to argue that it doesn’t need to be regulated strikes me as daft.
Synthetic Assets 