Dem candidates shine a light on "shadow banking"

The battle for the Democratic Party's presidential nomination has raised the profile of the U.S. economy's "shadow banking" sector. That's the portion of the nation's financial system that operates beyond the jurisdiction of government bank regulators.

Back in the run-up to the 2008 financial meltdown, it was non-commercial banks like Bear Stearns and Lehman Brothers that cracked first, setting the stage for the greatest financial collapse since the Great Depression.

Since 2008, partly in response to the tighter regulations imposed on banks, this shadow sector, which includes mortgage servicing companies, online payment services, and marketplace lending companies that link borrower and lender directly, have grown dramatically. This trend hasn't garnered headlines, but it's very much on the radar of the banking industry, consumer advocates and regulators.

While all three Democratic presidential contenders don't think the post-2008 reforms went far enough to prevent a repeat of the financial crisis, their approaches on what should be done now do differ.

Both Sen. Bernie Sanders and former Maryland Gov. Martin O'Malley have called for the reinstitution of the Glass Steagall Act. The Depression-era reform created a firewall between commercial banking and more speculative investment banking. Such a reestablished divide, Sanders and O'Malley reason, would reduce the odds that the U.S. Treasury, and ultimately U.S. taxpayers, would be on the hook for another bank bailout.

Portions of Glass Steagall were repealed by Congress in 1999 under President Bill Clinton, which supporters of deregulation said would make the U.S. financial sector more globally competitive. It's a move that many experts now say made the banking system riskier and helped bring about the financial crisis.

Democratic primary frontrunner Hillary Clinton rejects the idea of restoring Glass Steagall. Instead, she favors "stronger oversight for the shadow banking sector, which includes certain activities of hedge funds, investment banks and other non-bank finance companies."

The Democratic candidates may be onto something. According to the International Monetary Fund's October 2014 "Global Financial Stability Report; Risk Taking, Liquidity and Shadow Banking," the only country whose shadow banking sector is larger than the regulated banking sector is the U.S. The IMF has also documented dramatic growth of the shadow banking sector in the world's emerging markets.

While the IMF says shadow banking does expand access to credit and provide market liquidity, the organization warns that it "appears to contribute most to domestic (U.S.) systemic risks" in a way it doesn't in the U.K. or in Europe as a whole.

"Since the crisis, the ongoing tightening of bank regulation maybe encouraging a shift of traditional banking activities into the shadows," the IMF found.

The landmark Dodd-Frank legislation, passed in the wake of the Great Recession, created the Financial Stability Oversight Council to take a holistic view of threats to the nation's economic well being. As part of its mandate, the FSOC (led by Treasury Secretary Jack Lew) is responsible for identifying shadow banking entities whose possible failure could take down the broader economy.

So far nonbank behemoths like AIG (AIG), Prudential (PRU), GE Capital (GE), and MetLife (MET) have made the list of "systemically important financial institutions" that are subject to greater scrutiny by the Federal Reserve. (Met-Life is fighting the designation, and GE Capital's parent is attempting to sell it off to shake the designation.)

In it's 2015 annual report, the FSOC flagged the proliferation of shadow banking services and companies. "One challenge for regulators is the need to monitor new products or services in light of existing standards and regulations. Another challenge is the migration of activities to less regulated or unregulated institutions," FSOC concluded.

Wayne Abernathy, executive vice president of the American Bankers Association, said this parallel universe of unregulated financial companies may be costing his industry market share. While the economy has managed to chug along with a growth rate in the low single digits, Abernathy points out that in the most recent Federal Deposit Insurance Corp. data, the banking industry actually shrank by $20 billion.

"Regulators need to look at what are the risks and who are all the players. It's not enough to get your arms around banking," Abernathy told CBS MoneyWatch. "It's one thing to minimize risk, but are you just moving it to someplace where nobody is keeping an eye on it?"

For Dennis Kelleher of Better Markets, a Washington, D.C., nonprofit advocate for consumers, it's a mistake to make a distinction between official banking and shadow banking.

"There is an inaccurate and artificial claim that the banking sector and shadow banking sectors are separate silos," Kelleher said. "In reality, they're interconnected and interrelated. Shadow banking could not exist without the financing and product creation from the banking sector."

"We are still just halfway with the regulation necessary to actually make Dodd-Frank truly effective," he said, "but nobody expected the furious counterattack from Wall Street."