Headline: Should we really throw shade at shadow banking system?

Date: 2/21/2021

Body  I was listening to a wonderful article on the radio that mentioned the “shadow banking system.”  Sounded to me like a GREAT murder mystery.   To my surprise, I found an even BETTER story.   On the International Monetary Fund site, I found the following article Shadow Banks: Out of the Eyes of Regulators (imf.org)  It really does an excellent job laying out the facts that  can be even more engaging than the fiction.

What is the “shadow banking system?”

Shadow banking is a phrase made up by Paul McCulley in 2007 as he gave a speech to a gathering of the Kansas City Federal Reserve. Players in the shadow banking system are numerous and include investment banks, mortgage lenders, money market funds, insurance companies, hedge funds, private equity funds and payday lenders, all of which are a significant and growing source of credit in the economy.  Shadow banking refers to the “bank-like” institutions that engage in “maturity transformation” and the related “liquidity transformation”, to make money.    Banks will take the deposits made to them by consumers (to the Banks, these represent short-term liabilities which require very little interest to compensate them) and then lend these funds out on a longer-term basis (which requires higher interest rates coming in.)   This is how a bank makes money.  The key differences are 2:

  1. As a “last resort” Banks can borrow from the Federal Reserve.  The shadow banks cannot borrow from the Federal Reserve.

2,         Banks are insured.    The shadow banking system is not.

Further, some Banks take part in these shadow banking activities.   The best known activity is the credit-default swap.  (The buyer essentially makes payments to the seller until the maturity date, and if mortgagee goes into default, the buyer is paid a discounted fee by the seller.)

What is the origin story of these shadow banks?

In a few words, “Home Mortgages.”  For many years, institutions that are not banks have been making loans such as home mortgages.  What often happens is that a bunch of these mortgages will be bundled together and sold as a “security” to another institution, and this could happen a few times.  This trend was steady for a while, but really accelerated in 2007-2008.  For a while, this was a great business to be in, and these shadow banks took on more and more debt in order to purchase more of these mortgage securities; This debt financing is known as leverage, and can serve to increase profits (or losses.)  But, remember, these shadow banks are NOT regulated as Banks, and… remember the Great Recession?

What happened to these “finance companies?”

Many years ago, there was a ship called the Titanic, ran into an iceberg.   The going theory was that there would be a gaping hole in its hull that caused it to sink into the sea.   But, inspection with remote operated vehicles (ROV) suggest that it was instead point-damages where the rivets popped out.   This is similar to what happened to the finance companies.  Individual investors became concerned about the value of the properties and ran to pull out their money.  To produce the money, these companies had to sell their other assets at rock-bottom prices.  They quickly wound up with nothing left.  Worse yet, sometimes traditional Banks do get involved with these finance companies, so they too are affected.

How would this happen?   Banks now have to compete with these shadow players.   Let’s just think of home mortgages (but note that similar logic could apply to a variety of financial products.)  The Bank sees these shadow institutions offering mortgages for lower percentage rates of interest, and to compete, they lower interest rates.   Then, the Banks do what the can to “simplify” paperwork, which gives them less information on the mortgagor.    And, in this way, the problems of the shadow banks are now also owned by the other Banks.

What are the specific risks?

 Investor Safety–>Banks are insured by FDIC.   Money market funds offered by investment houses are not.    This shouldn’t be a problem, but, when investors panic, they quickly withdraw money and without the FDIC insurance, these institutions cannot withstand this kind of shock.   Bottom line: If investors were rational, this wouldn’t be a problem.   Investors are human, and gentle reader, we humans are not rational.

Liquidity Risk–>Related to #1, this is refers to the fact that shadow banks use nearly all of their deposits to underwrite longer-term loans, leaving VERY LITTLE to cover such “runs” on their deposits.   Please note that as there is no FDIC insurance, there is no reserve requirement on these institutions.  So, you get enough skittish investors, these institution can fail in a hurry.

Recession–>Recessions are nearly impossible to predict, so, there is no way for these institutions to proactively begin to save liquidity in preparation for a recession.

How large of a problem is this?

Transparency issues are being addressed, but since 2015, shadow banking represents 33% of banking activity in Europe, and 28% of the activity in the U.S.  The Financial Stability Board found that non-bank financial assets had risen to $92 trillion in 2015 from $89 trillion in 2014  .   In addition, peer-to-peer lending added more than $1.7 Billion  in loans in 2015 alone.   Quicken Loans (alone) has 17,000 employees and closed nearly half a billion dollars in loans between 2013 and 2018.   One expert said the following:

“It’s a wild west space,” a top credit strategist from Bank of America told the Financial Times this year. “The whole thing has exploded in size, and everyone is getting into it.”

So, shadow banking represents a large set of issues that we should get our arms around before it manifests again as a much larger problem. “Anytime you have this much money chasing loans, you are going to have accidents,” a banker told me recently.

Have we seen this movie before??

One person said, “history might not repeat itself, but it does rhyme.”    I think we might be hearing a phrasing similar to 2008.  “Anytime you have this much money chasing loans, you are going to have accidents,” a banker said recently.

Said in a different way, too much of the lending growth is driven by investors’ search for yield rather than borrowers need for new capital.    One key attribute to the defense of capitalism is that it provides the most rational allocation of scarce capital.   With investors seeking yield, some more rational projects might not be funded adequately, and some less rational ones might get funding, then fold.

Further complicating the picture, many regulators don’t understand the problems well enough to suggest rational solutions.  (Hard to blame them entirely, it is complicated)  It is difficult to understand where all of the risks are most densely packed.  Sometimes it’s difficult to see and appreciate the potentially corrosive effects of leverage.

What can be done?

Not long ago, some international banking regulators came up with an idea that might be used to avoid the 2008-type crisis.  Over-simplifying the idea, when certain economic indicators all light up green (like in 2008) banks should be required to withhold a larger amount of reserves.   This is  a pro-active response to the  demand for liquidity that might be not far off.   Currently, many of the market indicators are in agreement to be like 2008, but 4 out of 5  of the Fed’s Board of Governors decided not to place this extra restraint on Banks, right now.   The stink of it is that there might be political entanglements causing some of the Governors to vote as they did.

The Verdict

Anytime the government does anything to create an environment more friendly to business, there is always a danger that business can be made “too easy” and the effectiveness of regulation is compromised.  I guess the boil-out of all of these thoughts is, “Buyer, Beware.!!”  When you sign for a new credit card, when you sign up for a new bank account, be sure to ask questions first, especially if there is a term you don’t understand.  Usually, if there are many terms you don’t understand, this is a good reason to avoid that potential investment.    Turns out, mom was probably right when she said, “Be careful out there.”


Shadow Banking System Definition (investopedia.com)

What You Need to Know About Shadow Banking System Now | Kiplinger

The shadow banks are back with another big bad credit bubble – The Washington Post

Credit Default Swap (CDS) Definition (investopedia.com)

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

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