Shadow Banks and The Great Recession

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In last week’s post I looked at current financial reform and regulation, and why these are necessary to fix the economic situation in America.  I had looked into what this new regulation would entail and a lot of it was about regulating shadow banks.  According to the Paul Krugman column Financial Reform 101 there had been a lot of regulation of standard banks in the post-World War II period, which is why there had been such a long period of stability.  Unfortunately the regulations did not apply to “shadow banks,” institutions that carried out banking functions, but weren’t banks.  These shadow banks were able to operate without being controlled by the same regulations which standard banks were.  This enabled the shadow banks to make a lot of money really quickly, but at the same time left them very vulnerable to any risks, such as the mortgage crisis.  I want to look into the emergence of these shadow banks and the effect they had on the economic crisis.

In order to look into these shadow banks I want to look into the recent history of companies such as Lehman Brothers and Merrill Lynch.  I want to research the ways they operated and what risks they took that were dangerous.  I already know that Merrill Lynch worked closely with Enron, an obvious risk to begin with.  I want to look into court testimonies, interviews and investigations to determine what risks these companies took and how they lead to the financial crisis.  I think that these organizations operated in an open system.  I want to look into the ways that these organizations affected their environment and the ways in which their regulation-free environment affected them.  The actions of these organizations sent the economy into one of the worst recessions since the Great Depression and required the government to spend billions of dollars in order to keep the economy from collapsing. The environment also had an effect on the ways in which these organizations operated.  Because there were no existing regulations there was nothing to keep them from taking the risks they did.  I want to investigate the specific actions taken by Merrill Lynch and Lehman brothers and the ways they possibly affected the environment as well as the effect that any regulation or lack thereof had on their actions.  As I said I plan to look into testimony from things such as the Congressional Oversight Panel, and newspaper articles throughout the past decade about the operations of these companies.  I also want to look for scholarly articles regarding the lack of regulation, or Lehman Brothers or Merrill Lynch.

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6 Responses

  1. Has the realization that the ability of shadow banks to operate without any regulations contributed to the recession spurred the enactment of legislation to prohibit such uncontrolled risk-taking? Just like how Sarbanes-Oxley was the byproduct of learning what can happen without such rules the hard way I wonder if this problem has been prevented from happening in the future.

  2. Good point. They have started trying to take measures to prevent this from happening in the future. The Financial Crisis Inquiry Commission has been formed to look into the causes of the financial crisis. Also, Senator Dodd of Connecticut has proposed legislation that would regulate investment banking activity, however, many have argued that political divisions will impede the bill’s progress. This legislation may not ever be passed, or the bill might be weakened in order to appeal to more senators, possibly rendering it powerless. Unfortunately, I think it will be a while until any strong legislation regarding financial reform and regulation is passed.

  3. This topic is very interesting to me because it relates to my paper idea which deals with crisis management within these systems. I think lack of regulation within the system is a key idea to your topic. What do you think could have been done in order to ensure that companies such as Lehman Brothers and Merrill Lynch could have managed their risk effectively? Also, this lack of regulation was a large problem not just within shadow banks but also within other institutions that I have looked at as well.

  4. I think that these institutions needed better internal controls to monitor the risk they were taking and make sure that they were not undertaking too much risk. I think that part of the problem was that these institutions did not have much incentive to do so. Because there was little regulation monitoring the risk they were taking, there was no requirement to have these internal controls. These institutions were making large profits because of the risks they were taking, so since there was no regulation, why would they want to minimize risk since it would mean cutting profits. I think a lot of these institutions operated with a mindset similar to Enron, in that they took on however much risk was necessary in order to make a profit. In your research, what other institutions have you found that were affected by this lack of regulation?

  5. The shadow banking system is a great topic to investigate. As you say, it seems ripe for some opens systems perspective. I think you can also find scholarship in peer reviewed journals that can examine the rise and structure of the shadow banking system. This week’s chapter on networks may also help.

  6. FYI:

    Trying other social media platforms!

    Digg: http://digg.com/d31Ox2P

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