Shining a Light on Shadow Banks

49 Journal of Corporation Law 1 (2023)

47 Pages Posted: 2 Aug 2023 Last revised: 25 Apr 2024

Date Written: November 27, 2023

Abstract

To date, descriptive accounts and reform proposals have framed the problems arising from “shadow banking” as about the risks of lending and maturity transformation by nonbanks operating outside the guardrails of banking law. But shadow banks engage in the business of investing, not lending, and their ownership interests are often held by traditional banking entities. By ignoring the ownership structure and investment activities of shadow banks, the academic literature has overstated the risks that nonbanks pose to financial stability and underestimated the ability of existing regulatory frameworks to address the information and incentive problems posed by shadow banks.

This Article first shows that the innovative design of many securitization vehicles is to give banking entities residual and subordinated economic exposure to securitization vehicles without triggering a legal conclusion that the vehicles are bank “affiliates” or “investment companies,” and, thus, regulation under the banking laws or investment company laws. Nevertheless, this Article presents data showing that the traditional banking sector owned, controlled, and backstopped many of the securitization vehicles at the heart of the 2007–2009 financial crisis. Thus, most of these so-called shadow banks were instruments of the traditional banking sector, not bank competitors.

This Article identifies the shadow banks of most concern to ongoing financial stability as entities that would be regulated as investment companies but for an asset-based exemption from regulation under the Investment Company Act—especially when the shadow bank is backstopped by a banking entity. This Article advances a reform proposal that would update the boundary lines between banking entities, regulated investment companies, and unregulated investment companies. The banking laws should add an economic exposure test to the definition of “affiliate” to bring unregulated entities backstopped by banks, and indirectly backstopped by the federal safety net, into the regulatory perimeter. Moreover, the exemptions from the Investment Company Act of 1940 for investment companies that hold only certain types of assets should be narrowed or eliminated altogether. This bottom-up, transactional approach would better regulate risks to investors and the public than the top-down approach in the Dodd-Frank Act that relies on regulators identifying and regulating “systemically important” nonbanks.

Keywords: shadow banks, securitization, 2007-09 financial crisis, financial regulation, banking law, banking regulation, investment companies, investment funds

JEL Classification: G18, G01, G21, G23, K22, K23

Suggested Citation

Corrigan, Patrick, Shining a Light on Shadow Banks (November 27, 2023). 49 Journal of Corporation Law 1 (2023) , Available at SSRN: https://ssrn.com/abstract=4528631

Patrick Corrigan (Contact Author)

Notre Dame Law School ( email )

Eck Hall of Law
Notre Dame, IN 46556
United States

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