In our “Financial Crisis!” handout we received in class, we ran out of time to cover the last point on Shadow Banks and Why Did It Meltdown?
The subprime mortgaging was the trigger for the crisis, but the cause of the meltdown was the wild demand for mortgage-backed securities that shadow banks offered. As we learnt, shadow banks are banking systems that are unregulated, and that employed high-risk techniques such as short-selling and heavy leveraging (hedge funds).
Since shadow banks were unregulated, the dependency on them increased rapidly despite their existence in the shadows, outside of the regulatory controls governing commercial banking activity. Anyone from any given backgrounds who had loans rejected from regulated banks, could come to these banks to take out a loan.
The difference between regulated banks and shadow banks is that the former has enough assets that can be liquidated, should a bank run occur. However, shadow banks are not able to deal with bank runs, simply because it does not have deposit insurance. When creditors demanded for all their money back from the bank, these banks had to sell their long-term assets at depressed prices, leaving themselves insolvent[1] and causing serving as the catalyst to the recent economic meltdown.
[1] http://www.newyorkfed.org/newsevents/speeches/2008/tfg080609.html