Shadow Financial Services: Definition & Examples

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you will learn about the shadow financial services. These are firms that provide traditional banking services like lending, but they do so without as much regulation as typical banks. Many believe, these companies exacerbated the 2007/2008 Financial Crisis.

Shadow Firemen

Imagine you are cooking dinner. In fact, you decided to replace the old oven which was delivered and installed today. You preheat the oven as you get the lamb prepared. After a few minutes, you notice a bad smell. Oh, the neighbor must be cooking something gross again, you think to yourself. A few more minutes pass by and you notice the smell is coming from your new oven. Oh no.

You open the oven and realize you forgot to take out the plastic wrap that went around the inside of the oven. The plastic is smoldering. Then suddenly the fire alarm goes on. You try to dissipate the smoke, but to no effect. Next men show up who look like firefighters. They try to put out the smoke but they are just as ineffective as you. Then a second group of men show up. They also say they are firefighters. Weird, you think to yourself. Why would they send two sets of firefighters for a small fire? Eventually, the second group gets the fire under control.

You learn later, that the first group of men were not firefighters at all. Even though they looked and acted like firefighters, they were regular people hired by the apartment to ''fight fires.'' You then learned more about this group, including how they really do not undergo any training, and they do not thoroughly background check the ''firemen.''

Shadow financial services are like the first group of firemen above. While the firms may look, smell, and feel like a bank they operate outside the traditional financial services industry and are not held to the same regulation.

Shadow Financial Services

Shadow financial services firms, who occupy what is commonly known as the shadow banking system, are entities who create credit across the financial system and yet are not regulated like traditional banks. In plain English, this means shadow financial services extend credit (i.e. loans, money, etc.) to other parties but they are not held to the same regulation that traditional banks, who provide the same type of credit, are.

The key that allows these firms to slip by regulation is that they do not accept depositor's money. Money market funds, for example, are shadow financial services because they facilitate credit but they do not fund themselves with depositor's money, instead they pool together investor's money. Other examples of shadow financial services include: hedge funds, structure investment vehicles (SIVs), special purpose entity conduits (SPE), money market funds, repurchase agreement (repo) markets, and other non-bank financial institutions like student loan, mortgage, and auto loan lenders.

Going back to our firemen example in the introduction, the ''shadow'' firemen looked and acted like actual firemen, but they are not held to the same standard as other firemen. It's useful to know when you are dealing with parties who are or who aren't regulated. In many cases, appearances are misleading.

Pros and Cons of Shadow Financial Services

As with anything, there are pros and cons. Here are some of the most talked about benefits and drawbacks of shadow financial services.

Advocates say shadow financial services:

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