Shadow Banks and the Financial System Periphery

Photo by Augustine Wong on Unsplash

“Who knows what evil lurks in the hearts of men. The Shadow knows!”

If it looks like a bank, swims like a bank, and quacks like a bank, then it’s probably a bank, right? But no. There are new players in the financial system, with tactics and objectives that may resemble traditional banking in many ways but are unfettered by the regulatory framework. Shadow banks is the term—and despite the ominous, clandestine suggestion, you may have done business with a shadow bank without even realizing it. Many have become household names. Let’s walk through the story.

What Is a Shadow Bank?

The term shadow bank was coined in 2007 by economist Paul McCulley, right on the eve of the last financial meltdown. It refers to any non-bank financial institution that performs bank-like functions (mostly lending) but isn’t regulated like a bank. Shadow banks don’t accept deposits like traditional banks, which is the key distinguishing characteristic. Their non-acceptance of deposits excludes them from much of the regulatory framework that governs conventional banking.

This matters because so much of the 20th-century banking framework was built during the Great Depression and its aftermath, when Americans were most concerned about the loss of their savings if a bank failed. As a result, banking regulations centered around deposit safety. Institutions that don’t take deposits aren’t “banks” in the regulatory sense.

But while these modern financial operators can’t accept your deposits the same way Bank of America, Chase, or your local community bank or credit union might, they do lend money. They finance homes. They invest in businesses. They increasingly provide credit when others won’t—or can’t. They’re just not backstopped by the FDIC or subject to the same level of scrutiny from regulators.

So what are some examples of shadow banks? One large category is mortgage lenders without traditional brick-and-mortar, savings-and-loan-style operations. Rocket Mortgage, Mr. Cooper, and LoanDepot all fall into this category. Not only do they not have deposit operations, but they also typically sell their loans to investors rather than keep them on their own books (although to be fair, many traditional banks do this too).

Personal finance companies that offer personal loans or buy-now-pay-later services also fit the bill. SoFi, Affirm, LendingClub, and OneMain Financial come to mind. Firms specializing in auto lending—like Ally Financial and Santander Consumer USA—also operate in this realm.

The big players, too, are getting a piece of this market. Blackstone, Apollo Global Management, and Goldman Sachs are increasingly lending to businesses in the private credit market, functioning much like commercial banks but without the regulatory oversight or hurdles for borrower and lender alike.

From my perspective as a commercial lender, I’ve noticed a new business model emerging over the past decade: private individuals lending funds to local business owners and real estate investors. This often takes the form of hard money lending. It’s usually short-term and often collateralized by real estate or whatever asset the borrower is acquiring.

Hard money lending could be its own article someday, but in a nutshell, the borrower gets fast funding with minimal scrutiny, and the private lender gets the ability to charge a high interest rate—often in the 12–18% range—plus heavy closing costs and the right to foreclose if the borrower fails to pay.

I’ve most often seen this type of lending for flip projects (which banks don’t always want to finance) and from borrowers who can’t get approved by a traditional lender. That, of course, makes these loans especially high-risk for both parties—hence the high rates and steep fees. Sometimes, to be honest, the lending can feel predatory. Private lenders may knowingly lend to weak borrowers, expecting them to default so they can seize the collateral. There are stories of auto lenders financing a car purchase, repossessing the vehicle after a few missed payments, and then selling it again—sometimes repeatedly. But I also know several private lenders who have done a great job facilitating projects that might not otherwise have gotten done without their help, so it cuts both ways.

The Future of Shadow Banking

According to the Financial Stability Board, non-bank financial intermediaries now account for nearly 50% of all global financial assets. In the U.S., they dominate mortgage origination (including the companies like Rocket Mortgage and LoanDepot mentioned above) and have become major players in leveraged lending, private credit, and consumer finance.

Why has this happened? I see three major reasons (apart from the broader fact that Americans—and people worldwide—are addicted to debt):

1. Post-2008 banking regulations, while protective of consumers and arguably successful in preventing another Great Recession-style crash, added restrictions on traditional banks. While intended to reduce risk and raise capital buffers, they also made underwriting more complex and time-consuming. This left a vacuum—one that shadow banks stepped in to fill.

2. Low interest rates for more than a decade pushed investors to chase yield in riskier, less-regulated corners of finance. This included buying loans from companies like Rocket Mortgage. Low rates also spurred a real estate boom between 2015 and 2022. While traditional banks participated and benefitted, the demand expanded the periphery of lending, bringing in many new players. More people wanted to borrow, and more were willing to lend—especially for attractive yields.

3. Speed and flexibility. Shadow banks and private lenders aren’t bound by the same rules, so they can move faster and offer terms traditional banks can’t. I’ve long believed that an underappreciated variable in business is the ease of doing business. Many borrowers will gladly pay a higher interest rate in exchange for a fast, hassle-free process. Some of those same 2008-era regulations slowed things down for traditional banks, so people found other avenues.

Paying the Piper

This growth doesn’t come without consequences. The trouble with shadow banking is that when the tide goes out, you find out who was swimming without a suit—or maybe without a life preserver. Because these institutions aren’t subject to the same capital requirements, oversight, or liquidity rules as traditional banks, they’re more vulnerable when markets seize up. In a crisis, they can’t turn to the Federal Reserve for emergency lending or lean on FDIC insurance to reassure clients.

Banks, big and small, face stress tests and active oversight. If the OCC sees something risky at a community bank, it can sound the alarm and can force that bank to course-correct, deleverage, or seek a stabilizing merger.

But in the world of private lending and shadow banks, if borrowers start to default or investors pull out, the lenders can become forced sellers—dumping assets into a falling market and deepening the pain. This kind of fire-sale spiral is part of what made the 2008 crisis so severe.

That crisis also taught us how interconnected the financial world is. The opaqueness of shadow banking presents a systemic risk. Private markets and complex structures are hard to track. Regulators, investors, and even counterparties may not know how much risk is on the books or how intertwined these entities are. That means trouble in one corner—like a failing private credit fund or overleveraged hedge fund—can trigger ripple effects across the system. Things seem stable…until they’re not.

The Silver Lining Around the Shadow

It’s not all doom and gloom. Shadow banks serve a real purpose. They fill in the gaps left by traditional banks. They offer credit to borrowers considered too risky or unconventional, like startups, artists, or someone with a great idea but a thin credit file.

They also increase competition and diversify sources of capital in the economy. I’ve personally referred borrowers to private lenders for projects our bank didn’t have an appetite for, but who I believed in. Well-managed private lending and shadow bank activity can create opportunity.

In short, there’s a double-edged sword to shadow banking: it’s more flexible, but also more fragile.

What Comes Next?

This is the trillion-dollar question.

As interest rates stay high and banks continue to de-risk, expect shadow banking to keep growing. Private equity firms are launching massive credit arms. Hedge funds are pivoting into lending. Even insurance companies are getting into the game. Traditional banks like JPMorgan Chase are entering the shadow banking world themselves through private equity arms.

Jamie Dimon, CEO of JPMorgan Chase and a bellwether for big banking, has urged caution—even as his bank expands in this space. At an investor conference in May, Dimon warned, “I think that people who haven’t been through major downturns are missing the point about what can happen in credit … there could be hell to pay if the private‑credit industry falters. It reminds me a little bit of the mortgage industry.” And yet, JPMorgan Chase is expanding its own private lending.

Regulators are uneasy. There’s talk of new rules, especially around transparency, leverage limits, and systemic risk. But regulating the shadows isn’t easy as they don’t fit neatly into a box. We’re also in a period of deregulation in many areas under President Trump, with fewer restrictions on all manner of industries, not more.

One likely future is a hybrid system, where traditional and shadow banks blend and borrow from one another. That’s already happening. Some shadow lenders are applying for bank charters. Some banks are spinning off affiliates that act like shadow banks. The boundaries are blurring.

But here’s the bigger truth: finance always innovates faster than regulation. Every time the system becomes safer in one place, risk finds a new home. Shadow banks aren’t going away. If anything, they’ll define the next era of credit.

What worries me most right now is that the shadow banking world hasn’t yet faced a major test. Credit markets—both public and private—have held up remarkably well over the past five years through a global pandemic, political turmoil, and economic dislocation. But when a prolonged economic downturn hits us, which it eventually will, these markets, which haven’t truly been tested yet, could face real stress—and so could the rest of us as the ripple effects spread.

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Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com.