The Rise of the Shadow Banks

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The Rise of the Shadow Banks

In 2007, Paul McCulley of the bond fund PIMCO invented the term “shadow bank.”  He applied the name to financial instruments created by banks to sell risky loans as bonds.  Today, according to The Economist, shadow banks encompass “all financial intermediaries that perform bank-like activity but are not regulated as one.”1

At a time when banks are under increasing regulatory scrutiny and traditional loan officers are avoiding risk, shadow banks are thriving.

According to a “Future of Finance” report by Goldman Sachs, traditional banks are at risk of losing $11 billion in annual profit by the end of the decade as new competitors emerge in six areas:2, 3

  1. Consumer lending
  2. Small business lending
  3. Leveraged lending, or loans to noninvestment grade businesses
  4. Mortgage banking
  5. Commercial real estate
  6. Student lending

Tighter regulations are opening the playing field to new competitors because banks are now required to hold more capital to offset the loans they issue, making lenders less willing to write loans.  In the aftermath of the financial crisis, policy makers enacted several regulatory changes that have made lending more expensive for banks and their customers. 

According to Goldman Sachs Global Investment Research, these regulations include the following:4

  • In personal lending, the CARD Act requires banks to keep more capital on hand, which lowers returns and hikes interest rates on credit cards, which new competitors can beat with lower rates.
  • In small business lending, the Fed stress test program known as Comprehensive Capital Analysis and Review (CCAR) and other regulations that prevent banks from pricing risk into loans, make them vulnerable to unregulated shadow banks that can set higher rates on loans to borrowers that are higher credit risks.
  • In leverage lending, CCAR and “Skin in the Game” rules keep banks from getting involved in riskier deals, leaving opportunities for shadow banks to take those deals and collect high fees.
  • In commercial real estate lending, Basel III and CCAR demand that banks keep more capital on hand, which reduces profits, while shadow banks can take on bigger deals because they are not subject to the same rules.
  • In mortgage banking, Qualified Mortgage rules for underwriting and the Home Mortgage Disclosure Act have forced banks to approve fewer loans, while shadow banks have filled the void by issuing 42 percent of mortgages...

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