By Gillian Tett and Paul J Davies

Published: December 16 2007 18:33 | Last updated: December 16 2007 18:33

When the New York markets open on Monday, all eyes will be on Wall Street’s banks. As the US Federal Reserve, in a bid to ease the liquidity crisis, holds a novel type of money market auction to inject some $20bn of funds into financial institutions, investors and policymakers will be watching closely to see how many large banks bid for how much cash – and what that, in turn, indicates about their state of health.

Yet while investors are scrutinising some of the industry’s best-known names, a spectre will be silently haunting events: the state of the little-known, so-called “shadow” banking system

A plethora of opaque institutions and vehicles have sprung up in American and European markets this decade, and they have come to play an important role in providing credit across the financial system. Until the summer, structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) attracted little attention outside specialist financial circles. Though often affiliated to major banks, they were not always fully recognised on balance sheets. These institutions, moreover, have never been part of the “official” banking system: they are unable, for example, to participate in Monday’s Fed auction.

But as the credit crisis enters its fifth month, it has become clear that one of the key causes of the turmoil is that parts of this hidden world are imploding. This in turn is creating huge instability for “real” banks – not least because regulators and bankers alike have been badly wrong-footed by the degree to which the two are entwined.

“What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand,” Bill Gross, head of Pimco asset management group recently wrote. “Colleagues call it the ‘shadow banking system’ because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in that only Wall Street wizards could explain.”

By any standards, the activities of this shadow realm have become startling. Traditionally, the main source of credit in the financial world was the official banks, which typically forged business by making loans to companies or consumers. They retained this credit risk on their books, meaning that they were on the hook if loans turned sour.

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