Shining a Spotlight on Shadow Banking

The term “shadow banking” seems designed to frighten—for many, likely evoking images of ill-gotten cash funding nefarious activities and potentially destabilizing the financial system.^[i] No surprise, then, that US nontraditional lenders’ rise has fanned fears of a burgeoning credit bubble and 2008-style banking crisis. However, we think these worries misperceive a positive trend: Credit markets adapting to keep capital flowing to where it is needed most.

First, understand: “Shadow banking” is actually pretty benign—lending occurring outside the traditional banking system. Traditional banks operate by taking deposits—short-term loans from savers and depositors, in effect—and lending them out, primarily in the form of mortgage, auto, business and credit card loans.^[ii] Nontraditional banks may raise funds by borrowing (from banks or via bond issuance). They may also issue stock publicly or get venture capital backing. Finally, if all goes well, profits from earlier loans can fund new activity. (Or a combination of all those things.) While their borrowing methods are different, their lending activities—mortgage and business loans, mainly—are similar. These aren’t innately riskier than traditional deposit-based bank loans, much less designed to hide illegal transactions from regulators.

In some countries (see: China), most consumers and businesses access credit via the shadow banking system because the official financial system is state-controlled, hard to enter or lends only to the most creditworthy borrowers. The reasons behind the rise of US shadow banking are a little different. First, the US yield curve—which depicts Treasury yields over various maturities—has been relatively flat for much of this expansion. Since banks borrow at the short end of the curve and lend at the long, a narrower “spread” between the two—a flat yield curve—reduces loan profits. The Fed’s misguided quantitative easing (QE) entailed buying truckloads of long-term bonds, weighing on long rates and flattening the curve.

Although QE ended in 2014, a still-sizable Fed balance sheet and high investor demand for Treasurys—which offer an attractive return next to near-zero yields on sovereign debt elsewhere—have kept the curve flattish. That plus the Fed’s policy of paying interest on excess reserves (IOER) discourages lending to borrowers with less than sterling credit. Why take the risk when you can just park money at the Fed for an easy 2.35%?^[iii] Nonbank lenders aren’t immune to the flat yield curve headwind, but those who can find ways to trim costs and uncover profitable lending opportunities—their stated raison d’être—have an advantage over traditional banks. Plus, not being banks, they can’t make an easy buck parking money at the Fed. To make money and survive, they must lend.

Dodd-Frank is another major reason for nonbank lenders’ rise. The 2010 financial regulation imposed significant regulatory burdens on traditional banks, saddling them with steep capital requirements intended to safeguard the financial system by bolstering banks’ ability to endure losses. Again, this incentivized new entrants who don’t face the regulatory scrutiny and costs that come with taking deposits or (erroneously, in our view) getting a reputation of being “too big to fail.”

This is what industries do when conditions change—firms change structure, function or business model. Either existing players evolve, or new rivals pop up. Markets, like nature, abhor a vacuum. Businesses and households wanted credit, and the market provided it. The result: nonbank lenders have helped keep total US credit flowing—supporting the expansion.

Perhaps the best-known US nonbank lenders focus on mortgages—firms like Quicken Loans, Freedom Mortgage and loanDepot. Per Inside Mortgage Finance, nonbanks made over half of all mortgage loans last year, up from 9% in 2009.^[iv] Conversely, corporate shadow banking fears focus on leveraged loans—those made to companies with less than stellar credit. In recent weeks, these were the subject of a Congressional hearing and a mild warning from Fed head Jerome Powell, who said they could “pose a new threat to financial stability.”^[v] Leveraged loans are typically bundled into Collateralized Loan Obligations (CLOs)—bond-like securities linked to pools of high-yield business loans. Different CLO levels—or “tranches”—have differing yields depending on their place in the pecking order if a borrower defaults. For many, this carries a whiff of 2008.

However, we don’t think shadow banking poses a risk to the US financial system presently—nor do 2008 parallels hold water. As we have written here often, the primary culprit in 2008 wasn’t souring housing loans or the allegedly complex and shadowy securities linked to them. Rather, the well-intentioned but misguided “mark-to-market” accounting rule (FAS 157) transformed approximately $200 billion in loan losses into trillions in unnecessary balance sheet writedowns of allegedly “toxic” assets. (This, plus the government’s haphazard response, drove the financial panic, in our view.) Except, if held to maturity as intended, they mostly weren’t poisonous. Their problem was illiquidity, not inherent toxicity. Yet this rule was suspended in March 2009 and later revised. It no longer has the power to magnify losses on illiquid assets. So even if traditional banks hold CLOs and the market wobbles, there shouldn’t be a 2008-style vicious circle.  

If recession strikes, leveraged loans—and, perhaps, mortgages and other types of debt nonbank lenders finance—could suffer. But this would in all likelihood be the consequence of a downturn rather than the cause. Moreover, markets seem to be pricing in these risks already. Leveraged loans’ higher yields reflect some increased chance of delinquency, default and sensitivity to changing economic conditions. The fact folks are still sifting through the ashes of the last crisis looking for the next is a prime example of the persistent caution that has helped prolong this record-length bull market.