Time to Cast More Light On Shadows of Finance

The unusual advice, contained in a report by the Federal Reserve Bank of New York in 2010, sums up the regulatory efforts around "shadow banking"—the vast amount of financial transactions such as mortgage-backed securities and "repo" deals among banks that take place outside traditional channels.

So far, watchdogs around the world have made little progress beyond mapping out what shadow banking is. But the authorities still have to decide how to deal with a portion of the financial industry that dwarfs "classic" banking and yet is inexorably and dangerously intertwined with it.

In the U.S., legislators and regulators have tried to tackle some aspects of shadow banking, notably by mandating centralized clearing and exchange-trading for derivatives and greater supervision of nonbanks such as hedge funds. But given the global nature of the sector, those efforts will remain piecemeal and isolated unless the international regulatory community is shaken from its torpor and joins in.

The stakes aren't trivial: by focusing mostly on old-fashioned lenders, the postcrisis regulatory regime might fail to prevent the next explosion.

The point about shadow finance isn't just that it is big—an estimated $60 trillion—but that it has a track record of destabilizing the system.