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A house with a large foregclosure sign in the foreground.
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filling the banking void

Source: Getty

Dark Shadows? 

Breaking the Banks

Why you should care

A new generation of so-called shadow banks are helping the economy get going — but with unknown risks.

This editor’s pick comes from October 31, 2013.

The financial news has been abuzz about JPMorgan Chase’s record $13 billion penalty agreement over the bank’s lending practices leading up to the 2008 financial crisis. And rightly so — it’s refreshing to see at least a little responsibility being taken for the train wreck of subprime mortgages, exotic securitizations and suddenly frozen cash flows. The official response to the financial crisis has often focused less on justice than on the simple goal of never letting this happen again, with bailouts trumping just deserts for the good of the system at large. By 2010, legislation like the Dodd-Frank Act and the international Third Basel Accord added new regulations for bank behavior, limiting the amount of risk they could take on and implementing stress tests to keep better checks on the institutions’ health.

But the new regulations go only so far — and, in some ways, might be making things even riskier. The real reason the subprime crisis was so big and so bad has to do with a larger, wilder group of entities collectively (and pejoratively) known as shadow banks — companies that offer banklike functions, such as loaning money — but aren’t subject to standard regulations regarding risk, leverage and depositor insurance. The upside of all this is that shadow banks can be more nimble and innovative, creating opportunities for both investors and those in need of loans.

But the new regulations go only so far — and, in some ways, might be making things even riskier.

Though the term was first used in 2007, shadow banking had been around since the birth of the first money market funds in the 1970s, and had surpassed the amount of traditional bank liabilities by 1995. The system really took off in the early 2000s — between 2002 and 2007, the short-term commercial paper loans issued by shadow banks rose from a few hundred billion dollars to several trillion. Shady, inscrutable players found their way in and opaque processes abounded until the whole edifice collapsed.

It’s here that a new (and arguably much more respectable) class of shadow banks has grown up — in both senses of the term — since the crisis. Entities ranging from hedge funds to reinsurers, business development companies (BDCs), real estate investment trusts (REITs) and structured investment vehicles (SIVs) are providing the financial services the banks are no longer able to offer. Often the people running these things are smart veterans from traditional banks who favor a downright conservative approach. And they’re running a huge chunk of the whole system — today, estimates for the total amount of money in the shadow banking system top out at more than $100 trillion, far more than the traditional banking sector.

Annaly at at the oepning bell of the NY Stock Exchange.

Source: NYSE

Annaly Capital Management at New York Stock Exchange

Perhaps the leading example of the new kind of shadow bank is Annaly Capital Management . They’re a REIT that buys up mortgage debt. By mid-2013, they had more than $102 billion in assets and a market cap over $11 billion — not bad for a company that doesn’t even have a Wikipedia page.

Estimates for the total amount of money in the shadow banking system top out at more than $100 trillion, far more than the traditional banking sector.

Other big players in the shadows include private-mortgage giant Chimera (whose name isn’t ominous at all), and BDCs like Ares Capital and Apollo Global Management , who offer multimillion-dollar loan packages to businesses. These new shadow bankers aren’t entirely unregulated — many of them are publicly traded, and all have to meet specific criteria to maintain their tax status. But these requirements are far less constricting than Dodd-Frank, and as a result these guys are able to make loans at higher rates to a broader swath of individuals and businesses.

And there are the shadow banks you probably have heard of: hedge fund giants like Blackstone and Carlyle, who have morphed from traditional private-equity players into enormous asset managers with loan and debt products like what traditional banks used to offer.

All this seems to be, for the moment, a good thing, helping to get capital moving as the recovering economy lumbers along — and doing a lot to make subprime less of a dirty word. But down the road there’s always the risk that, as happened before the crisis, less savory shadow banks will rise up. “Shadow Banking 2.0 is in its very early stages,” economic journalist Robert England — author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance — explains via email. “Further, a huge swath of Shadow Banking 1.0 is still with us.” The 2008 crisis, England says, was fueled by a dangerous combination of low interest rates and an increasing appetite for risk — allowing the avarice of the worst payday lenders to meld with the dangerous slice-and-dice innovation that left many institutions buying and selling financial products they didn’t understand. Today, England notes, we have only the low interest rates; risk tolerance is yet to return.

Since the 2008 crash, Dodd-Frank and other new regulations have made it much more difficult for banks to make the kind of bad loans and risky repackaging that fueled the crisis. Much of this is for the better — your cousin with no employment prospects is no longer going to be offered a McMansion mortgage. But the regulations have hamstrung the banks for dealing with clients who fall just outside the limits marked by Dodd-Frank. So your other cousin — who might not qualify for a traditional business loan but is nonetheless a good bet — is forced to look outside the banking sector.

Your cousin with no employment prospects is no longer going to be offered a McMansion mortgage. But the regulations have hamstrung the banks…

Obama with Barney Frank and Christopher Dodd after signing the financial reform bill.

Source: Corbis

President Barack Obama with Senate Banking Committee Chairman Christopher Dodd, House Financial Services Committee Chairman Barney Frank (center), and House Majority Leader Steny Hoyer on July 21, 2010.

The truth is, right now the shadow banking system meets an important need, but there are some things the U.S. government could do to reduce that need, by making it easier for banks to provide more liquidity for the system. The Basel rules were set up to be universal, reducing the amount of regulatory arbitrage (where financial institutions shop around for the countries with the most lenient rules). Dodd-Frank, unfortunately, can work against that goal, providing a regulatory speed bump that winds up pushing capital out of the global banking system — making it harder to keep tabs on which institutions are healthy and which are in danger.

Canada manages to do quite well regulating its banks, in part because officials with fewer institutions to track are able to regulate by supervising rather than by imposing one-size-fits-all rules. Of course there’s the option of simply extending more regulation to the shadow banks itself — collateral requirements could be increased , and some economists even suggest extending government guarantees to cover them. Stephen Brown and his colleagues at NYU’s Stern Business School suggest new rules to make hedge funds more transparent about their risk, and to discourage fast withdrawal of money due to bad fund performance.

If you have too many rules, you lose out, but if you have too few, you can lose big.

The trick with any sort of financial regulation is, of course, that if you have too many rules, you lose out, but if you have too few, you can lose big. Finding the amount of regulation that both big lenders and those in need of financing will say is just prudent enough is an impossible task. In the end, England notes, individual investors need to be even more diligent than the regulators about monitoring the amounts of risk and leverage in the system.

If one of the lessons of the crisis is that it’s better to keep all the risks on the table where they can be understood, it might be less risky to loosen some of the new constraints on the banks, and welcome a few trillion dollars back out of the shadows.

Cover Image: Getty

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