Monday, November 27, 2023

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.” Thus, these securitization vehicles are not regulated 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 

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.

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