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The new rulers of the financial system

A series of new financial companies are capturing commanding positions in the new American financial system.

Banking regulators with their plethora of rules and regulations and unending lawsuits have prevented U.S. based banks from meeting the needs of the economy. This created a vacuum into which alert entrepreneurs have established commanding positions.

This is both good and bad. It is good because the United States is developing a new financial system that is immune to the depredations of the legislators and regulators. It is good because over the next five years the new companies will flourish creating meaningful stockholder wealth.

Jin Lee | Bloomberg | Getty Images

It is bad because the safeguards that existed under the old system have been systematically removed by the regulators. Therefore, when the next recession emerges possibly five, possibly seven years from now it will be harsher than the events of 2008.

The restraints

The limitations that regulators have placed on banks have been significant. They have demanded that banks increase their capital to levels never experienced before in this country. They are requiring these institutions to place more of their available assets into cash and Treasury investments rather than loans. They penalize banks for lending to low income households and in many cases businesses of any type. The regulators have removed liquidity from the financial system and have stopped large institutions from making direct investments in innovative start-up ventures.

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The results are clear in one sense. The amount of bank loans in the United States was actually lower at the end of 2013 than they were in mid-2008, five years ago, according to the latest figures available from the Federal Deposit Insurance Corporation. At the same time, bank cash deposits at the Federal Reserve from 2008 to the present have soared by over 5,400% to the unheard of level of $2.7 trillion. In sum, money that should have been used to grow loans in the private sector has been buried at the Federal Reserve instead.

Emerging companies

However, the private sector did not lie dormant as the regulators pulled banks away from supporting the economy. Instead it has exploded with new non-regulated companies that are meeting the nation's demand for funds. Every sector of the economy is being fed by the new firms. A simple listing of them by industry would be as follows:

  • Private equity investors
  • Business development companies
  • Hedge funds
  • Master limited partnerships
  • Real estate investment companies
  • Monoline financial companies (mortgage brokers, auto finance companies & more)
  • High-frequency traders
  • Payday-loans companies
  • Pawn shops
  • The underworld (loan sharks), and
  • Other offshore money pools.

Business loans

Private-equity investors are raising hundreds of billions of dollars that are being invested in business enterprises. Business-development corporations are supplementing these activities. Hedge funds are now making money available for a wide range of speculations that include everything from traditional businesses to real estate to personal loans.

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Real estate

Tens of thousands of houses are now owned by private investment companies. Commercial real estate projects are being financed by traditional lenders like real estate investment trusts. However, private-equity investors are bidding for and obtaining stakes in commercial real-estate loans.

Targeted lending

Master Limited Partnerships are fueling growth in the energy industry. Mortgage bankers have arisen from the dust to fund the residential housing industry. Automobile lenders are now seeking public listings because of their need for funds to meet the demand for their services.

Market liquidity

High-frequency traders are now providing the liquidity in the markets — liquidity that was once made available by specialists on now virtually defunct organizations like the New York Stock Exchange. Private-equity funds and hedge funds add more liquidity through proprietary trading. Plus, large foreign banks have entered the markets adding liquidity. The only entities not allowed to play are the U.S. banks.

Consumer debt

Consumer-oriented lenders are also benefiting. There are payday-loan companies and pawn companies that are providing low income consumers with the funds they once acquired from banks. Consumer-finance companies are sure to rise in the vacuum created by the regulators in this sector.

The risks

As long as the economy rises, and I feel very positively that it will for the next few years, these companies will flourish. They will be funded by the growing desire by holders of money to put it to work at higher returns than are available from the traditional regulated banking industry. Investors are well advised to seriously consider these new companies for potential investment.

However, the safeguards that were in effect in the old-time banking industry are not in effect in this new unregulated financial market. I call it the old-time banking industry because in the newly regulated banking industry the safeguards have been removed. The Fed cannot aid a failing bank, it must help dismantle it. A strong bank cannot help a weak bank. It will be sued if it does this. Banks cannot help troubled non-bank financial companies.There are strict regulations that penalize them for doing this.

There will not be any new money source for the non-bank financial company that may be weakened by the next recession. The opposite will occur and these companies will fail throwing assets on to the market. This will destabilize the system.

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America now has a new financial system. It is driven by excessive regulation on one side and a complete laissez faire system on the other. Good times are expected for the next few years in the creation of unregulated non-bank financial companies. However, winter will come, as it always does, and the grasshoppers will freeze when it does.

Commentary by Richard X. Bove, an equity research analyst at Rafferty Capital Markets and the author of "Guardians of Prosperity: Why America Needs Big Banks" (2013).