The shadow banking system is a network of non-depository financial institutions – investment banks, structured investment vehicles, conduits, hedge funds, and other non-bank financial entities that serve as intermediaries to channel savings into investments. Due to the fact that they do not take deposits, they escape a myriad of limits and laws imposed on traditional banks. Before the crisis, shadow institutions used to borrow via short-term, liquid markets and then used the funds to invest in longer-term illiquid assets. When the housing bubble burst, lenders and investors started to avoid taking on the credit risk, and short-term borrowing dried up almost overnight, making these institutions unable to raise money for their own operations. Compounding their woes was the inability to get funds from their collapsing investments in securitized assets, which were now considered “toxic” in investment terms.

Choice A is incorrect because the shadow banking system, while operating outside of traditional banking regulations, is not exclusively made up of institutions engaged in illegal activities or money laundering. While the lack of regulation can make these institutions more susceptible to such practices, it is incorrect and oversimplified to categorize the entire shadow banking system in this way.

Choice B is incorrect because while some institutions in the shadow banking system, like money market funds, may invest in short-term financial assets such as Treasury bills (T-bills), it is not a defining characteristic. The shadow banking system is broad and diverse, with different entities focused on various types of assets and investments.