Without a safety net, banking is unstable. This proposition finds support in economic theory. In an influential analysis, Douglas Diamond and Philip H. Dybvig showed that banks without deposit insurance exhibit multiple equilibria—one of which is a bank run.  And financial history confirms this hypothesis. Banking panics were common in the U.S. before the enactment of deposit insurance, but nonexistent thereafter.
The apparent instability of banking has given rise to a standard policy response in the form of a social contract (a phrase borrowed from a marvelous speech by Paul Tucker of the Bank of England).  That contract entails certain privileges that are unavailable to other firms: most notably, access to central bank liquidity and federal deposit insurance. These privileges amount to a safety net, and they stabilize banking. The social contract also imposes obligations—activity restrictions, prudential supervision, capital requirements, and deposit insurance fees. These obligations are designed to counteract the moral hazard incentives implicit in the safety net and protect taxpayers from losses.
Historically, this social contract has been limited to depository banking—firms that take deposits and use them to invest in illiquid loans. This limitation is not surprising. At the time the social contract was established, and for decades thereafter, depository banking was the dominant form of credit intermediation in the U.S. financial system.
In recent years, however, this situation changed. A set of institutions emerged that performed the basic functions of depository banks, but without submitting to the terms of the social contract. Indeed, the very existence of many of these institutions has been predicated on being free from inconvenient constraints. Collectively, these institutions have come to be known as the “shadow banking” system.
The term “shadow banking” suggests something mysterious or elusive, but the reality is rather mundane. As used herein, “shadow banking” refers simply to maturity transformation—the funding of pools of longer-term financial assets with short-term (that is, money-market) liabilities—that takes place outside the terms of the banking social contract. A non-exhaustive list of shadow banking institutions would include: repo-financed dealer firms;  securities lenders; structured investment vehicles (SIVs); asset-backed commercial paper (ABCP) conduits; some varieties of credit-oriented hedge fund; and, most importantly, money market mutual funds, which absorb other forms of short-term credit and transform them into true demand obligations.
These institutions share a common feature: They obtain financing at short duration through the money markets, and they invest these funds in longer-term financial assets. This activity is the essence of “banking,” and the short-term financing sources on which it relies are the functional equivalent of bank deposits. The quantity of uninsured short-term liabilities issued by financial firms is the most meaningful measure of shadow banking. And, by this measure, shadow banking came to far surpass depository banking in its aggregate scale.
Importantly, while the social contract (and the associated safety net) applies only to depository banks, the instability of maturity transformation does not observe such formalities. Runs and panics are not limited to “banking” narrowly defined. Rather, they are more general phenomena. As the Diamond-Dybvig paper observes, any firm that funds long-term assets with short-term obligations will exhibit the same unstable qualities. Put differently, there is no characteristic unique to bank deposits that creates the propensity for liquidity crises. The short-term obligations of shadow banks are just as susceptible to runs and panics.
The instability of shadow banking became apparent in the recent financial crisis. Indeed, at the height of the crisis, very nearly the entire emergency policy response was designed to prevent shadow bank defaults through a series of “temporary” and “extraordinary” interventions. These interventions were very likely necessary to prevent an economic catastrophe and were skillfully executed. Their success is a testament to the determination and skill of a group of dedicated public servants. Still, no one views this situation as a triumph of policy.
The discussion above makes no claims to novelty. Various strands of this narrative have appeared in works by Timothy Geithner, Gary Gorton, Paul Krugman, and Paul Tucker, among other places.  But this discussion raises an obvious question: If the safety net is conducive to stability, why not extend it to shadow banks?
The conventional response is that the perimeter of the safety net should not expand—that it should, if anything, contract. The reason is moral hazard. Extending the safety net to shadow banking would vastly expand the government’s explicit commitments to the financial system. And safety nets encourage risky behavior, giving rise to inefficient resource misallocation and burdening taxpayers with losses once insurance funds are exhausted. This line of reasoning implies that, far from extending the safety net, we should look for ways to reinforce “market discipline” by short-term creditors of maturity-transformation firms. (Retail-oriented deposit insurance is generally admitted as an exception, on consumer protection grounds.)
Advocates of this conventional view often acknowledge that shadow banking poses a problem for financial stability. However, they typically propose that this problem be addressed not with a safety net, but rather with regulatory restrictions—such as risk controls, supervision, and capital requirements. In other words, their solution is to apply to shadow banks the obligations, but not the privileges, of the banking social contract. (The recent financial reform bill, insofar as it addresses shadow banking at all, more or less adopts this approach.)
But even proponents of this risk-constraint approach admit that it has shortcomings. First, regulatory risk constraints are costly from an efficiency perspective: They reduce credit formation and commercial activity. And second, there is no identifiable level of such constraints that is certain to ensure stability. Indeed, the Diamond-Dybvig view implies that only a safety net for short-term creditors can ensure stability by addressing the basic collective action problem that produces run-behavior. If this view is correct, then “market discipline” by the short-term creditors of maturity-transformation firms is inconsistent with systemic stability—indeed, runs and panics are the very manifestations of market discipline by short-term creditors.
This discussion seems to point toward a discouraging conclusion: Either we extend the safety net to cover shadow banking, resulting in a very substantial expansion of explicit government commitments to the financial system; or we seek to reduce the instability of shadow banking through regulatory risk constraints alone, and learn to live with a costly and incomplete response to the shadow banking problem.
But perhaps the question should be posed in a slightly different fashion. We have asked whether the social contract (including the safety net) should be extended to shadow banks—a question that implicitly takes the dimensions of the existing maturity-transformation industry as a given. But if the objective is to ensure that all maturity transformation takes place within the social contract, there is of course another alternative: We might disallow financial firms outside the banking social contract from engaging in maturity transformation—that is, preclude such firms from financing themselves in the money markets (i.e., require them to “term out” or rely on “term funding,” in industry parlance).
And, of course, it is possible to adopt a combination of both techniques. We might expand access to the social contract to include some categories of firms that are currently shadow banks, while disallowing the remaining shadow banks from conducting maturity transformation. In any case, the phenomenon of “shadow banking” would no longer exist. By definition, shadow banks brought within the social contract would no longer be “shadow” banks, but rather just banks. And shadow banks precluded from relying on money-market funding would no longer be shadow banks, but rather term-funded financial intermediaries of one type or another. (In reality, many of these institutions would not be economically viable on a term-funded basis.)
This approach would represent a significant departure from existing methods of financial regulation. It would impose legal funding restrictions on many types of financial intermediaries that traditionally have enjoyed unfettered access to the institutional money markets. And it would necessitate the development of functional policy criteria to determine eligibility to engage in maturity transformation.
The author’s recent paper, Shadow Banking and Financial Regulation, explores some of the implications of this approach to financial stability regulation from the standpoint of economic efficiency, and compares it with available alternatives.
The full paper is available for download here.
 Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy (1983) 91, 401–19.
 Paul Tucker, “Shadow Banking, Financing Markets and Financial Stability,” Remarks to BGC Partners Seminar (2010).
 A shadow bank can exist within a consolidated group that contains one or more insured depositories. The most obvious examples are the dealer operations of the large money-center banks (JP Morgan, Bank of America, and Citigroup). Those operations rely heavily on overnight financing through the repo markets.
 Timothy Geithner, “Reducing Systemic Risk in a Dynamic Financial System,” Remarks at the Economic Club of New York (2008); Gary Gorton, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference (2009); Paul Krugman, The Return of Depression Economics and the Crisis of 2008 (2009); Paul Tucker, “Shadow Banking, Financing Markets and Financial Stability,” Remarks to BGC Partners Seminar (2010).