Welcome to the new shadow financial system, a world where regulators are hampered and bankers are bold. The "old" shadow financial system, before the bubbles burst, thrived on ample liquidity and lax regulations. The new one will be less liquid but will flourish thanks to the many new and incomplete regulations that will characterize the post-crisis world.
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The old shadow financial system included a dizzying array of institutions -- investment banks, broker-dealers, money-market funds, hedge funds, special investment vehicles, and many more highly specialized companies. These companies were not tightly regulated and had the ability to mobilize vast quantities of money even if they did not have the capital to adequately back up their oversize credit and trading operations. Most of it wasn't illegal, and certainly not all the system's products were toxic or fraudulent. Many did spread risks, lower costs, and open opportunities for consumers everywhere. But, as we now know, the shadow financial system was also a Wild West where peddlers of incomprehensible financial products, reckless speculators, and even Ponzi-schemers roamed, looking for opportunities to make fortunes betting with other people's money.
The crisis wiped out many players in the shadow financial system, the criminal Bernie Madoff being the most spectacular example. But others, like hedge fund manager John Paulson, who hauled in $3.7 billion in 2007 and whose fund earned an incredible 37.6 percent return in 2008, profited handsomely from the downturn and are just waiting on the sidelines now. They still have access to large pools of capital and to the people, technologies, institutions, and investment vehicles worldwide that will allow them to continue exploiting the opportunities created by market imperfections and deficiencies in government regulations.
But the new shadow financial system will be different, for two main reasons. First, under the ancien régime, money was abundant and projects of all kinds -- including many bad ones -- were easy to fund. This ample liquidity fueled excesses everywhere, but especially in the shadow financial system, which had outgrown the $10 trillion regulated banking sector to become a massive $10.5 trillion market itself. Surely in coming years liquidity will be tighter, but not tight enough to strangle the new shadow financial system out of existence.
Even in the post-crash world, the golden rule of finance has not changed: Products and schemes that offer a return commensurate with their risk will find the capital they need. And the new shadow system will be rife with attractive investment opportunities. In fact, many will emerge as a result of the second difference between the old and the new systems: more government regulation.
Finance today may be global, but politics are still local. Financial regulations do not result from a technocratic exercise, but are primarily the outcome of a political process. And because these politicized outcomes will vary across countries and continents, the new global regulatory system is bound to be full of inconsistencies, contradictions, and gaps. These are the nooks and crannies where the players in the new shadow financial system will be getting rich.
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