Interesting article from The Guardian (We all go together when we go), based on Paul Krugman's new book about the current financial crisis:
The shadow banking system is formed by financial institutions that aren't banks from a regulatory point of view but nonetheless perform banking functions. The system includes innovative financial products such as CDOs and hedge funds. Often these products offered better returns than those of the conventional banks. Investors were paid higher interest rates than they would have received on bank deposits, while borrowers paid lower interest rates than they would have done on long-term bank loans. There's no such thing as a free lunch, Milton Friedman told us, yet these deals seemed to offer just that. How did they do that?
Well, the answer seems obvious, at least in retrospect: banks are highly regulated; they are required to hold liquid reserves, maintain substantial capital and pay into the deposit insurance system. In the shadow banking system, borrowers could bypass these regulations and their expense. But that also meant they weren't protected by the banking safety net: if they ran out of funds, they couldn't turn to the US Federal Reserve to bail them out.