Prior to the 2008 financial crisis, the Federal Reserve had an important role – to solely act as a “lender of last resort” to traditional commercial banks. But during the crisis, the financial support was extended to many non-banking firms like money market mutual funds, the commercial paper market, mortgage-backed securities market and the tri-party repo market. Besides the extensive lending, non-commercial banks (also known as shadow banks) like Bear Stearns and Lehman Brothers were first to fail, triggering one of the worst financial crises across the world.
A shortage of short-term bank debt, a lack of liquidity in the commercial paper market and a sudden drop in confidence in the money market mutual fund industry initiated the crisis. Moreover, shadow banks helped in generating low-quality loans to investors seeking higher returns. All these financial products were traded through a network of financial institutions as part of the “shadow banking system.”