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
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.