Shadow banking is back in focus.

In the 2008 crisis, banks took the biggest hit and the lion’s share of the blame for the economic collapse.

Banks entered the crisis with too little equity capital. Their loan portfolios consisted of garbage loans. From 2008 to 2012, 414 banks with almost $700 billion in assets failed. Hundreds more had to seek a merger with financially secure institutions.

This time, the banking system enters into an economic slowdown in much better shape.

Equity levels are at historical highs. Credit conditions are as strong as they have even been in the banking system. Thanks to regulations such as the D0dd-Frank Act in the aftermath of the credit meltdown, banks have backed away from much of the riskier corporate lending markets.

The Problems with Shadow Banking

That’s not the case for the shadow banking system. It has exploded in size to fill the void in riskier markets created by the pullback of the banking system. Private equity firms, fintech lenders, business development companies, and private credit funds jumped into the marketplace in the last decade and represent much more of a risk that the highly regulated banks. As usually happens near the high end of a credit cycle, loan quality has been declining, and many of the borrowers may struggle to survive, and that condition could well spread to their lenders.

To compound the potential problem, many of the Business Development Companies and secured lending funds are publicly traded at can be liquidated on a daily basis by investors. This could also pull capital from lenders at the time they need it most and accelerate the decline in value.

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