By March 18, 2008, the FOMC had reduced the federal funds rate by three percentage points to 2.25 percent – including two unusual 75 basis point reductions one on January 22, 2008, and the other on March 18. The FOMC was well aware of the impact that the financial crisis could have on the real economy and was actively trying to offset these adverse effects. The FOMC made an additional 25 basis point reduction in the federal funds rate on April 30, and then held the policy rate constant over the summer at 2 percent. The Panic of 2007 turned into the Great Recession of 2008 following the bankruptcy of Lehman Brothers on September 15 and the Fed’s emergency assistance to American International Group, Inc. In response, the Fed reduced the federal funds rate to essentially zero by mid-December, instituted swap lines to provide dollar liquidity to foreign central banks, added new liquidity facilities to target specific sectors of the shadow banking system and began to expand its balance sheet through asset purchases. To deal with problems in commercial paper market, the Fed introduced on October 27 the Commercial Paper Funding Facility (CPFF) to backstop issues of commercial paper. In an effort to restart the securitization market, on November 25, the Fed announced the Term Asset Backed Securities Loan Facility (TALF).
First, it is very clear that “shadow banking” is not the same as the non-bank financial sector. This is not a debate about the appropriate regulatory framework for the whole of finance. For example, the vast majority of hedge funds are not shadow banks, and don’t trade in the credit markets or especially illiquid markets. Second, non-bank intermediation of credit is not a bad thing in itself. Indeed, it can be a very good thing, helping to make financial services more efficient and effective and the system as a whole more resilient. We must remember that as we make policy. But, as we know from this crisis and from previous ones, true shadow banking can weaken the system. Regulatory arbitrage, which is always with us, can distort and disguise channels of intermediation. That leads me to my third general point. Shadow banking comes in lots of shapes and colours. There are degrees to which any particular instance of shadow banking replicates banking. The liquidity offered by some shadow banks relies pretty well entirely, and more or less openly, on committed lines of credit from commercial banks. In these cases, the liquidity insurance offered by the shadow bank is “derivative”; there is a real bank in the shadows. But for other shadow banks, liquidity services are offered without such back-up lines. In those cases, claims on the shadow bank have, in effect, become a monetary asset.