Shadow banking, a system of institutions and activities that provide credit but are not subject to regulatory oversight, represents about 40 per cent of the activity in the traditional banking sector.
Timothy Lane, deputy governor of the Bank of Canada, says shadow banking is an important alternative to the traditional banking system because it fuels competition and innovation.
But Lane says the system also carries inherent risks, which were exposed during the recent global financial crisis.
"The experience of the crisis points to a need for reforms that will enable shadow banking to continue to play a useful role while addressing its inherent risks," said Lane.
Lane made his comments during a speech to the CFA Society Toronto on Wednesday.
In some cases, the vulnerabilities of shadow banking are similar to those in traditional banking, such as the susceptibility to runs, which is when a large number of investors simultaneously withdraw their money.
But shadow banking also carries unique risks, he said.
For instance, the securitization of government-insured mortgages has more than doubled over the past five years, which may be exacerbating the buildup of household debt, said Lane.
Also, banks and other institutions may be tempted to issue mortgages to unqualified homeowners so they can repackage those mortgages into securities and transfer the risk to investors.
This is what happened in the "originate to distribute" model that has been credited with creating the U.S. housing bubble and precipitating the economic crisis.
Institutions should been required to have some "skin in the game" because that would give them a financial incentive to make sure the assets backing the securities are of good quality, Lane said.
However, Lane said it's important that regulations aren't overzealous and stifling to the economy.
"Risk is inherent in the global financial system," he said.
"We can't stamp it all out, nor would we want to. Rather, the goal is to create incentives so that risk is allocated and managed appropriately."