During one sleepless coffee-fueled night I stumbled across a financial term that made me feel uncomfortable: “The Shadow Banking System.”
Immediately I thought of Alex Jones-fueled conspiracies and/or a rabbit hole I wasn’t fully prepared for. What I found was much worse.
The shadow banking system wasn’t some back-alley secret society that wore matching fez hats. No, they were hiding in plain sight. The shadow banking system was ubiquitous and I didn’t even know it.
Shadow banking includes non-bank mortgage lenders like Quicken Loans, pension funds, hedge funds, ETFs, fintech companies like PayPal, insurance companies and anything that isn’t a part of the traditional banking system.
These institutions are the puppet master’s behind the U.S. economy.
What You Don’t Know About the Shadow Banking System
Economist Paul McCulley first coined the term ‘shadow banking’ in a prophetic 2007 speech. The name refers to any financial business that isn’t regulated in the same ways as conventional banks.
During the internet age — and with the inception of apps like Robinhood, Cash App and PayPal — the shadow banking system has quadrupled in size.
Today the shadow banks manage over $60 trillion in assets and none of it is FDIC-insured. This would be fine if it weren’t for the fact that these institutions play around with your investments like Monopoly money.
‘Too Big to Fail’
Every financial institution in America practices something known as “Fractional Reserve Banking (FRB).” This means that instead of keeping all your money in a safe, banks use it to make loans and other investments that multiply their money like crazy.
Fractional reserve banking is so old that even goldsmiths used to do it.
There is one major flaw in this system, however. If everyone tomorrow said, “Hey, I’m going to go withdraw all of my money” then the banks would be scrwed. This is why many economists poo-poo the idea of FRB. Especially in the wake of a crisis like COVID-19 or the housing crisis, FRB can jeopardize the entire U.S. economy.
This is why the Federal Reserve places safety measures to ensure the central banks never fail. They classify these central banks as ‘SIFIs,’ or Systemically Important Financial Institutions and protect them at all costs.
Here’s the key difference between SIFIs and Shadow Banks
SIFI’s have to follow stringent requirements imposed by the Fed:
- They must have higher capital requirements, which usually sit around having 10% total liquidity (which is still a laughable figure).
- They must have operational risk capital, which is a fund just in case all hell breaks loose. This is 15% of their profits from the last three years.
- They are FDIC insured up to $250,000. This rule alone cost JPMorgan $12 billion in the last 10 years.
- They must be more transparent about their spending and report it to the public at large.
None of these regulations are brought down on shadow banks, yet they are twice the market size of normal financial institutions.
If the shadow banking system failed our economy wouldn’t survive.
How the Shadow Banks Fail
Historically speaking, fractional reserve banking and fiat currency (money backed by nothing but trust) has always failed.
When a crisis arises — or the masses begin to expect high inflation rates, as they are now — people go to banks to withdraw their money. Unfortunately, they’ll find there isn’t enough to go around.
Now consider this: Shadow banks are the lynchpin of the U.S. economy; they manage nearly two-thirds of the country's deposits. Yet these loosely regulated institutions have barely enough liquidity to “ last even 30 days,” during a crisis, according to Berkley real estate professor Nancy Wallace.
We saw this with the Robinhood/GameStop short squeeze. Robinhood had to forcibly halt the trading of GME because they didn’t have enough liquidity on hand. They exhibited fascism just to stay afloat. This tweet didn’t age well…
The worst aspect of the shadow banking system is that they are too big to fail. Despite being poorly regulated by the government, the Fed has no choice but to bail them out during a crisis or else risk the entire economy.
Shadow banks get a free pass to be reckless. Yes, there is a protected class and you’re not it.
This is why the 2008 housing crisis could have been much, much worse. It’s also why economists warn the impending economic crisis will make 2008 look like pre-school.
The Takeaway
“We Should remember that that the quantum risk [of fractional reserve banking] may not have changed — it just got moved to a less regulated environment.”
JPMorgan CEO Jamie Dimon said that after expressing his concerns about the shadow banking system.
The Fed is not going to crack down on shadow banking. They have to let it run its course and destroy everything. And who knows how bad the crisis has to be for the government to realize that bailing out these reckless and sometimes corrupt organizations endangers middle-class wealth.
They don’t care. As economist Peter Schiff once remarked, “the economy has a headache and the Fed has the cure. The cure is a handgun. Just pull the trigger and no more headache.”
Shadow banks might kill your parent’s pension. They could flatten the stock market to smithereens. They could bankrupt America as we know it.
During these uncertain times consider alternative investments like gold, silver, or Bitcoin as the actions from the shadow banks start to catch up with them. Call it karma.
Ever since I was a child it was my dream to become a financial advisor. Unfortunately, it never came true. Therefore I am not a financial advisor and you should do your own research and not just listen to random people on the internet. Nothing contained in this publication should be construed as investment advice.