Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

'Shadow banking' set for breakout year in 2015

Shadow banking set for breakout year in 2015

As traditional banks face tighter restrictions and the demand for credit grows, a clear winner is beginning to emerge.

Recovering from the black eye it received during the dark days of the financial crisis, the unregulated shadow banking system continues to gather both assets and attention, the latter from industry insiders who believe the climate is right for strong growth ahead.

A recent report from the Financial Stability Board put assets for nonbank lending institutions at $75 trillion after growing more than 7 percent in 2013.

While the FSB has been pushing hard for new rules governing shadow banks, most focus on reporting requirements so regulators can get a better understanding of how much risk is posed to the broader banking system. The board believes it's important, though, to maintain a healthy industry

"The current regulatory reform agenda, led by the FSB, has yielded important progress. However, many of the agreed principles have not yet been implemented nationally," the board wrote in its Global Financial Stability Report. "The challenge for policymakers is to strike the right balance between containing systemic vulnerabilities related to shadow banking risks and preserving the benefits of shadow banks."

Shadow banking came under a negative light during the crisis for helping to spur low-quality loans as well as the securitization process that sold bundles of those debt products to investors craving the higher yields they provided.

Wild wild west of lending

But as more Dodd-Frank-related banking regulations come on line, bank analysts believe it will drive flow to the nonbank part of the lending framework.

Consumer loan demand is finally beginning to rise after a lackluster 2013, with the third quarter showing household debt rising 2.7 percent and business debt up 5.2 percent, according to the Federal Reserve.

"In advanced markets, various types of funds have been stepping in to provide long-term credit to the private sector as banks have been lending less," the FSB said. "In fact, lending by shadow banks contributes significantly to total lending in the United States and is rising in the euro area."

Indeed, banking analyst Dick Bove said the new regulatory framework is providing a direct feeding tube to shadow banks.

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In a note to clients, the vice president of equity research at Rafferty Capital Markets said he has "projected repeatedly that the actions of the government and the bank regulators would stimulate the creation of a huge, unregulated shadow banking system. Well this is no longer a projection; it is a reality."

The industry, which features multiple components such as basic storefront lenders as well as insurance companies, hedge funds and real estate investment trusts, is getting more company, from peer-to-peer lenders. LendingClub staged a highly successful initial public offering earlier in December, raising $870 million in its debut, and others are expected to follow in 2015.

"The regulators have set the stage for the growth of the shadow banking sector," Bove said. "They have created a system with more risk than the one that existed before. However, with risk comes opportunity. I expect that we shall see more opportunity in nonbank stocks than banks for some time."

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Those risks also were noted by the FSB, which said the U.S. has particularly high exposure among global economies.

"The GFSR finds that in the United States, shadow banking accounts for at least a third of total systemic risk, (measured as extreme, low-probability losses to the financial system), similar to that of banks," the board said. "This contribution to systemic risk has been growing since the global financial crisis."

At more than $24 trillion, the U.S. has the largest exposure of any reporting country, followed by the U.K. and China. Despite its own government restrictions, China's shadow system, at about $4.5 trillion, has been growing about 34 percent annually in recent years, according to S&P and Thomson Reuters.

Fed Vice Chair Stanley Fischer addressed shadow banking growth several times in 2014.

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"Among the most important of the possible unintended consequences is that toughened regulation of banks will move some financial activity out of the banking system and into the shadow banking system," he said in August.

Following up those concerns, he said at a symposium earlier this month that "we have not started to deal with the problem of shadow banks."