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Only the Shadow Knows…
By Mel Miller

In 2012, I first shared my concerns about the rise in shadow banking. In fact, I listed shadow banking as one of the “gray swans” during my annual presentation at The SRI Conference that year.

The broad definition of “shadow banking” includes any bank-like activity undertaken by a firm not regulated as a bank. That would not only include credit (a more restrictive definition), but also mobile payments offered by Vodafone, for example, bond-trading platforms by technology firms, or even investment products sold by firms like Blackrock.

The Financial Stability Board, an international watchdog which guards against financial crises, defines shadow banking as “credit intermediation involving entities and activities outside the require banking system”—in short, any lending other than through a bank.

No matter which definition is used, shadow banking is not only alive and well, but is growing exponentially. Why are non-banks growing so fast? It’s because orthodox banks are dealing with expanding regulations, higher capital requirements, fines, and legal problems resulting from the last financial crisis.

The last financial crisis resulted in banks needing to raise capital relative to their loans. Banks are limited in the methods available to improve capital ratios by 1) issuing additional capital, 2) cutting lending and investments, or 3) cutting costs. Since the Great Recession, banks have been doing all three.

Shadow banking has moved into the void left by the retreating banks. Bank lending to U.S. corporations is still approximately 6% below its 2008 high, and even lower in the Euro area. The largest American banks have also shrunk their consumer lending.

“Direct lending” or “private debt” funds are more than filling the gap. These funds raised $97 billion last year alone worldwide, and have a goal of raising $105 billion in 2014 according to Private Debt Investor magazine. Business development companies are funding mechanisms exclusive to the U.S. which have grown ten-fold since 2003, according to the SEC. Currently they own assets composed of primary loans to businesses of approximately $63 billion.

When one adds up all the forms of “shadow banking,” the Financial Stability Board estimates it accounts for approximately the same amount of financial assets as banks and is growing at a much faster pace. Should this be reason to celebrate or is there a concern?

In general, diversifying credit risk from banks to “shadow banks” offers appeal because losses are born by investors and not the FDIC (Federal Deposit Insurance Corporation; taxpayers, actually). Yet my concern is the ability of “shadow banks” to underwrite credit and the lack of regulation compared to banks.

As an example, the investment community has come to expect that money market funds are safe; therefore, any credit losses resulting in a fund “breaking the buck” would shake the markets. Also, the growth of pay-day-loan operations is largely due to banks retreating from direct consumer loans. The rates charged by these firms far exceed the regulated bank rates. Pension funds are also a significant investor in private debt funds and some worry about the financial impact of losses on investor confidence.

All financial crises are caused by greed, speculation, and lack of transparency. I feel the traditional banking system is much safer today than before the last financial crisis. I can only hope regulators also consider the risk of “shadow banking” and regulate appropriately.

For a more in-depth review of the topic, please see the May 10-16, 2014 issue of The Economist. This article, The Lure of Shadow Banking, summarizes the entire special report.

 

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Posted: June 9, 2014