Why Risky Shadow Banking is Unlikely to Go Away

NEW YORK – From the Federal Reserve’s inception over a century ago, there have been banking free-loaders that enjoy the benefits of the Central Bank while avoiding the costs and requirements of membership. That’s according to a Columbia Business School study that examines the factors which led certain banks to join the Federal Reserve in its early days. The study, recently published by the National Bureau of Economic Research, also examines why other financial institutions instead chose the unregulated shadow banking route – a system known for encouraging excessive risk-taking that has been at the root of recent financial crises.

"There are important lessons to be learned from the historical successes and failures of the Federal Reserve that are useful when considering current reforms to the system," said Charles Calomiris, co-author of the study and a professor at Columbia Business School. "Although there is no doubt that the Federal Reserve reduced liquidity risks for banks and provided significant benefits, there are banks that will continue to find ways around the rules – unless regulations are applied consistently across the financial industry."

The research focuses on the role the Federal Reserve System played from 1914 (when it began operating) to 1924 in addressing seasonal liquidity risks, which occurred primarily during the harvest season when there was high demand for credit and currency. Despite the success of the Federal Reserve in allowing banks to expand their loans and reduce seasonal swings, the study reveals that banks were slow to join; less than eight percent of state-chartered banks were members during its first decade. Several factors drove this resistance, but one was the most influential: a loophole which gave non-member state-chartered banks indirect access to the Federal Reserve’s discount window through their affiliations with member banks. This meant that banks could get emergency funds when they needed it without being required to join the Federal Reserve or being subject to its costs and regulations.

The research paper, "Liquidity Risk, Bank Networks, and the Value of joining the Federal Reserve System," was co-authored by Charles Calomiris from Columbia Business School, along with partners at Colgate University, the Office of Financial Research, and the Federal Reserve Bank of Richmond.

To learn more about cutting-edge research being performed by Columbia Business School, please visit www.gsb.columbia.edu. 

About Columbia Business School

Columbia Business School is the only world–class, Ivy League business school that delivers a learning experience where academic excellence meets with real–time exposure to the pulse of global business. Led by Dean Glenn Hubbard, the School’s transformative curriculum bridges academic theory with unparalleled exposure to real–world business practice, equipping students with an entrepreneurial mindset that allows them to recognize, capture, and create opportunity in any business environment. The thought leadership of the School’s faculty and staff, combined with the accomplishments of its distinguished alumni and position in the center of global business, means that the School’s efforts have an immediate, measurable impact on the forces shaping business every day. 

To learn more about Columbia Business School’s position at the very center of business, please visit www.gsb.columbia.edu.