Edited by Kern Alexander and Rahul Dhumale
Chapter 2: The Shadow Banking System as a New Source of Financial Turmoil
Tom Burns Editors’ abstract: Tom Burns analyses the structure of the so-called shadow banking system as one that was largely based on private law. It was unable to cope with a liquidity crisis because of its inherent defects. Unfortunately, these defects were not fully appreciated by the banking regulators during the development of this parallel banking system. The chapter goes on to argue essentially that the private law system (left to its own devices) became too complex and opaque and began to under-price credit risk. It was thinly capitalised, had no lender of last resort and had a tendency to produce serious conflicts of interests. The privately regulated shadow banking system was therefore in poor condition to withstand a liquidity crisis. The chapter highlights the importance of developing adequate public law principles of financial regulation to support existing private law doctrines which proved inadequate in controlling and mitigating the damages created by excessive financial risk-taking. INTRODUCTION The thesis of this chapter is that there was a lack of adequate domestic and international financial regulation in the field of securitised credit, which led to the growth of an unstable parallel or shadow banking system in America and the UK. This so-called shadow banking system was one that was largely based on private law. It transpired that it was unable to cope with a liquidity crisis because of its inherent defects. Unfortunately, these defects were not fully appreciated by the banking regulators during the development of this parallel banking system. Why was...
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