The idea of the shadow banking system was in some way, not only tolerated by regulators, but encouraged by regulators. They thought, "Let's get some of these risks off the balance sheet of the traditional banking system. Let's get interest rate risk off the balance sheet of the traditional banking system. Let's get credit risk off the balance sheet of the traditional banking system." They thought that would be a good thing. The traditional banks became an originator of loans which they packaged, securitized, and then sold to the shadow banking system, which then raised funds in the money market from mutual funds and asset-backed commercial paper that they issued to whomever. It was avoiding the traditional banking system entirely in this regard, and also avoiding all the regulation of the traditional banking system as well as all the regulatory support of the traditional banking system.
The first sentence is important. If you read through the papers coming out of the regulatory community from 2000 through 2006, I will bet that you find many more references to "better dispersal of risk" or "innovative risk management tools" than to concerns about shadow banking. The fact is, we had regulators looking at the issue of systemic risk, and most of them were saying it was all ok.
An interesting tidbit:
UBS started to say if AIG isn't going to sell us insurance at this cheap rate, we are going to make a plan to buy just 2% insurance and then make a plan to do "dynamic hedging" ourselves, which is a problem. That means when the price goes down, we sell, assuming that there would be a buyer on the other side.
Merhling's solution is for the government to be a risk insurer of last resort. That sounds to me like Freddie Mac and Fannie Mae, which did not work well at all. But Merhling says,
the important thing for government intervention here is to get that price closer to a reasonable rate...
Thus, the insurer of last resort has to charge a very high premium.
With all due respect to Professor Mehrling, I think that this is unworkable. The market will figure out a way to make the insurer of last resort take much more risk than it thinks it is taking. That is what the market did to AIG, as Merhling points out. I see no reason to expect that the government insurer will always be able to outsmart the market.