However, while a bank performs this transformation of maturity, liquidity and credit risk from end to end within a single institution, the shadow banking system involves a wide range of institutions and markets in the process. In particular, the shadow banking system has included money market mutual funds, enhanced money funds, other real money accounts and securities lenders as providers of short-term funding; banks, industrial loan companies, independent finance companies and other non-bank firms as originators of private credit; and an array of entities including structured investment vehicles (SIVs), securities arbitrage conduits, real estate investment trusts, broker dealers, clearing banks, hedge funds, mortgage insurers, monoline insurers and credit rating agencies as part of the maturity and credit transformation between the lenders and the borrowers. Given the number of steps and firms involved, the process of intermediating credit through this system was a complicated one. However, it is not the multiplicity of steps itself that was problematic; indeed, analogous steps would be taking place within a financial intermediary in the traditional banking system. What was problematic was that these steps involved a wide range of firms that did not have adequate coverage under any one regulatory umbrella and that did not operate with the benefit of either government-guaranteed liabilities or the Federal Reserve’s discount window. The shadow banking system grew rapidly in the years leading up to the crisis. By the middle of 2007, the volume of outstanding credit that was securitized had reached more that $ trillion.

It is impossible to determine with some degree of accuracy whether such a bubble, in the sense of a speculation-driven price increase, has indeed formed. Central bankers are not more ignorant than investors and traders, nor are they more intelligent or better informed when it comes to the valuation of companies. One might argue that a crash is not so much the result of exuberant cash flow expectations for individual companies but rather the consequence of a sudden increase in discount rates, causing a dramatic downward adjustment of all present values. The relevant discount factors are the combined result of time preference, risk preference, and the prevailing perception of uncertainty. History has taught us convincingly that time preference is a relatively stable factor. The problem, therefore, lies more in a sudden shift of risk preference and the perception of uncertainty. If these two determinants could be stabilised, much would be achieved already. This task, however, also presupposes some “superior knowledge” and “deeper insight” on the part of central banks relative to the market. Such assumptions are unrealistic. Moreover, central banks, with the instruments they have at their disposal, do not have the possibility to deflate a presumed bubble all on their own. Interest hikes would certainly be a possibility. In so doing, however, one would have to accept consequences in the real sector which could be completely counterproductive. Finally, if central banks were obligated to avoid stock market excesses, this would have extremely disastrous moral hazard implications.