The Rise & Risks of Shadow Banking

Bigger isn’t always better. In 1912, the inaugural voyage of the RMS Titanic attracted some of the most prominent individuals of the time. Wealthy passengers, including John Jacob Astor IV, Benjamin Guggenheim, and Isidor and Ida Straus, were eager to travel on what, at the time, was the largest and most sophisticated ship ever built. The cruise liner featured luxuries including a swimming pool, a gymnasium, restaurants, and even the ability for passengers to send messages over the ship’s radiotelegraph transmitter. Advanced engineering features such as watertight compartments, remote-controlled doors, and a double hull gave many people the impression that it was unsinkable.Despite the Titanic’s size and sophistication, a single iceberg was all it took to breach the ship’s watertight compartments — with devastating consequences. In a similar way, the rapid rise of shadow banking is creating a financial ecosystem that appears robust on the surface but harbors risks that could undermine its stability. As shadow banking activity continues its rapid rise, fueled in part by lending from traditional banks, there are growing concerns that the lack of transparency and regulation surrounding such lending could result in a Titanic-sized disaster for the financial system. Overview of Shadow BankingShadow banking activity involves credit and lending outside of traditional banks by non-regulated institutions without access to funding from central banks or credit guarantees. Shadow banking’s popularity has risen substantially in recent years. As organizations such as hedge funds, private equity funds, mortgage lenders, and buy-now, pay-later companies have stepped up their lending activity to individuals and businesses unable to access capital through traditional banking channels, shadow banking has become a major piece of the pie. According to the Financial Stability Board, shadow banking activity now represents $250T, approximately 49% of global financial assets. The banking industry is intricately involved as well, with traditional banks having loaned more than $1.2T to the shadow banking sector, according to the Federal Reserve. In fact, data from Fitch Ratings shows that lending from banks to shadow banks was up 20% YoY, as of March 31, 2025, compared to commercial lending for the same period, which was up only 1.5%. Factors Behind Shadow Banking’s GrowthThere are a few standout reasons why shadow banking has seen the growth it's experiencing. Here are some of the factors behind the trend:

Risks of Shadow Banking to Traditional BankingThe increase in shadow lending has caused concern among industry experts, who fear that the lack of regulation of the sector means any risks could go without notice and potentially result in a scenario reminiscent of past financial crises, such as the 2008 mortgage crisis or the 2023 collapse of Silicon Valley Bank. Last summer, the Federal Reserve proposed rules that would enable the regulator to collect more comprehensive and granular information about the banking industry’s exposure to shadow banks. US regulators are not alone in their concern. The European Central Bank (ECB) has been keeping a close eye on shadow banking and warning about the risks such activities could pose to the global financial system since 2021. Even Fitch has expressed concerns about the growth, noting that the meteoric increase in shadow bank lending “warrants close monitoring, as historically excessive growth in credit has led to asset quality problems that negatively affect banks.” Concerns about shadow banking include liquidity mismatches and the risk that if investors lose confidence and begin withdrawing significant sums of money that shadow banks may not be able to fulfill all the requests. This is a particular risk because shadow banks lack access to the liquidity of central banks, and if they fold like Silicon Valley Bank did, it could result in market turbulence and bank runs for consumers and businesses who don’t know the difference between shadow banks and insurance-backed institutions.There’s also the risk that major failure by a player in the sector, such as a money market or mutual fund, could cause widespread panic among investors. There are also fears that the lack of oversight of the sector could lead to exploitation of regulatory gaps and result in excessively high-risk lending and credit creation that could destabilize the financial system. Another risk that experts point to is the possibility that ongoing growth in the sector could make it more difficult for traditional financial institutions to operate by making it costlier for them to borrow money. This would ultimately reduce the amount of lending available to companies, particularly smaller businesses. Amidst ongoing uncertainty about how, or if, shadow banking will ultimately be regulated, it’s important to keep in mind the factors that contribute to the popularity of shadow banking, particularly the ones that lead to higher risk. Financial institutions should be cautious regarding their lending to organizations that fall within this sector and take steps to avoid overexposure.