The Dangers of Shadow Banking

You have probably heard the term by now, “shadow banking”. However, many people don’t understand the risks it poses because they do not understand exactly what it is.

Shadow banking by all estimates is greater in size than the global banking system. By some estimates, it is greater in size than the global economy.

Comparison. You see lots of stories about how the Chinese shadow banking system poses a threat to the global economy. However, according to Bloomberg, the US shadow banking system is nearly twice the size of the Chinese shadow banking system, with China accounting for 16% of estimated shadow banking programs, while the US accounts for and estimated 31% (almost 1/3 of all shadow banking globally). In 2016, China began enacting policies to rein in their shadow banking problem. This is aside from the fact that most Chinese banks are nationalized. Nationalized banks cannot be shadow banks or pose the level of risk that privatized shadow banking systems do. In the US, any attempt at regulating shadow banking has met with legal, economic and political resistance.

What is it? Shadow banking is comprised of financial institutions and systems which are not held accountable to regulatory agencies the way officially recognized banks are. In the US, financial products and institutions are typically regulated by the Federal Deposit Insurance Corporation (FDIC) and Securities and Exchange Commission, with other regulatory agencies which oversee various smaller segments of the financial market. These agencies ideally place limits on how much financial institutions can loan out in relation to their deposits, practices that reduce fraud or economic/financial risk to the public.

Who is it? Shadow banking (I’m tired of typing that out. Let’s abbreviate it SB, okay?) is comprised of financial institutions which have a wide range of influence. You either right now or have in the past done business with SB entities without knowing it. They include such entities as hedge funds, short term lending agencies like payday lenders and vehicle title loan companies, home equity lenders, insurance companies and many investment firms. It also includes entities such as GoFundMe. However, the largest and most dangerous of all involve financial derivatives and credit default swaps.

Why are they popular? SB entities generally offer the chance of higher returns on investment compared to regulated institutions. However, a major reason they can offer higher returns is that the financial products they offer tend to be high risk. Their loans and products have a much higher default rate than standard financial products. Think of high interest loans to high risk borrowers.

The dangers. The dangers involved with SB is the fact that they do fall outside the regulations that regular banks are subject to. Regulations which require banks to maintain a certain level of collateral deposits as a percentage of how much they can loan out. If the economy or a specific entity show signs of a higher default percentage, leading to decreased returns or even loss on investment, investors in these entities can withdraw their entire investment without notice. If large investors or large numbers of investors withdraw their investments, it causes a run on that institution or even an entire SB industry category. That can have drastic effects alone but it can also have a domino effect, especially if a large SB company offers multiple products.

Not limited to non-banking entities. One huge problem with the SB system is that regulated entities often invest large sums in the SB entities or loan money to them. The SB system had a major role in the 2008 crash thanks to high risk loans and mortgages by SB companies which were packaged as lower risk loans in “bundles” which were purchased by standard banking institutions. However, banks are well known to establish their own SB companies as well. The obvious risk with this is that if these entities fail, they bring down large banks.

Regulation does not stop it. Some may believe that legislation like Dodd-Frank placed limits or regulations on the SB system. Not at all. Dodd-Frank only addressed standard banks and did not address the SB system at all. Many candidates receive campaign donations from SB companies. Some economists claim that if the SB system were eliminated that the economy would suffer greatly. However, all agree that it is an extreme danger which should be regulated.

Shadow Banking steals from the legitimate financial system. Were SB brought under control and regulation, it probably would result in less investment by some. However, it would result in greater stability in the financial system. SB investments divert funds from legitimate, regulated, more transparent financial systems. The fact is that returns on legitimate investment systems suffer as a direct result of funding diverted to the SB system, causing lower returns. SB is popular simply because of lesser regulation and oversight.

SB and regulated markets are tied together. As noted above, regulated systems and SB systems are tied together. However, even when not directly tied together, they are intrinsically tied because of shared investors. Some may believe that if the stock market and regulated systems retract that SB systems will expand. As seen in 2008, the opposite is true. When financial markets retract, they have a domino effect causing all markets to retract concurrently. Many businesses have a combination of funding from regulated and unregulated sources. Thus, when large businesses or a large number of businesses fail, it has an effect on all the above. When investors see a risk of losing because of a retraction, they pull funding from all investments in similar streams. In addition, Quicken Loans is a SB entity, now the largest mortgage lender in the country. Other mortgage lenders are also SB entities, though smaller.

Cyclic effect. As employers see reduced profits, they reduce staffing. When this happens in large numbers as we have only begun to see, it means the consumer market retracts. More consumers default on loans of all kinds. In the case of SB lenders, they are much faster to pursue vehicle repossessions, foreclosures, etc. This is an attempt to claim the property, charge the initial borrower and resell the property to a second borrower at a secondary profit. Yes, this is illegal for regulated lenders but not for unregulated lenders. In the interim and when this fails, SB profits decline. When profits decline, investments decline. When investments decline, the interest rates on any loan offers increase. This causes more rejections and more defaults. All of this reduces finances available for consumers to spend, causing a further decline in consumer spending, bringing us back to reduced profits for employers and the cycle continues. This cycle happens very quickly.

So, while shadow banking is typically described in terms which seem abstract or which affect only large investors, as you can see it absolutely affects you personally in very real terms. The fall of the stock market can mean the fall of shadow banking. The decline in each one and both can affect your credit, your employment, your housing, your retirement savings and on and on.

Wonder what Libertarians will think about this?

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