What is shadow banking? The Financial Stability Board said there is no common definition in its Shadow Banking: Scoping the Issues. It tries to define it as "lending by any organisation outside the regulated banking sector that creates systemic risk or opportunities for regulatory arbitrage, particularly if long term assets are being funded by short term liabilities, and those assets are securitised and/or re-hypothecated." This is close to the prime brokerage model for investment banks. Here banks use the repo markets to fund themselves on a daily basis, using the assets (securities and cash) in the prime brokerage accounts of hedge funds as collateral. During the crisis of 2008, Bear Stearns, Goldman Sachs and Morgan Stanley could not fund themselves because hedge funds moved their assets from the banks. Because of the lack of collateral, the repo markets and daily funding, were diminished for them.
Basel III, the new global regulatory standard, will set tighter liquidity and capital ratios for banks. Banks are also divesting their proprietary trading desks. These changes will lead to an increased cost of funding for prime brokers and, therefore, for hedge funds as well.
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