Regulation typically focussed on individual institutions, not recognizing the fallacy of composition – that systemic stability could be threatened even if individual institutions within the system are stable. A whole network of bank-like institutions – now called the “shadow banking system” – grew and flourished outside the regulatory regime of banks.
Regulatory arbitrage became common practice as banks shifted risk to affiliated entities in the shadow system and evaded capital requirements. Warnings ignored It is not as if the risks to financial stability were brewing silently.