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Growth of shadow banking spurs warnings of a new credit crisis

Shadow credit: A hidden risk for markets?
Shadow credit: A hidden risk for markets?

The substantial growth of shadow banking — the vast, largely unregulated system in which non-bank lenders provide credit and financial services — poses a substantial risk to investors in the U.S. and around the world, according to some experts.

As technology has enabled smaller companies to perform more functions previously relegated to large banks, and as regulations on large financial operators have constrained their operations, shadow banking has grown by about 25 percent since the credit crisis, according to researchers Jeremy Josse and Craig Zabala.

Shadow banking institutions are "not risky inherently, and they provide an extremely important role in the economy," said Josse, a longtime investment banker focusing on financial institutions. Speaking Thursday on CNBC's "Trading Nation," he noted that "because I believe that banks have been so constrained by Dodd-Frank and their lending capabilities, we've seen this huge growth in shadow credit, in many forms — in the forms of commercial lenders, independent commercial lessors, consumer finance companies, mortgage REITs, BDCs [business development companies], credit funds."

"That on its own might not be a bad thing, but at a certain point we could have a repeat of the 2008 situation," added Josse, who is also the author of the recent book "Dinosaur Derivatives and Other Trades."

He reminds investors that "the credit crisis was caused by shadow banking," specifically the lending done by mortgage lenders.

One of the points he makes in the book is that financial risk can generally only be moved, rather than removed. In this case, the inherently risky process of lending has been moved from the highly regulated large financial institutions to the lightly regulated shadow banks — quite contrary to the purposes of the new regulations themselves.

To be sure, the issue has not escaped the attention of the regulators. Federal Reserve Vice Chair Stanley Fischer said at conference last week that shadow banking is not adequately handled in the U.S., according to The Wall Street Journal.

"The big goals of the reforms and regulation that took place in Dodd-Frank have been achieved in certain areas of the banking sector, and I worry a little bit about the fact that we in the United States do not have very good mechanisms for dealing with the non-bank sector, the shadow banking system," the Journal quoted Fischer as saying.

Shadow banking's momentum partly comes from an unfilled need.

"One driver of shadow banking is large corporations, asset managers and other institutional investors who want deposit equivalents where the banking system is not suited to provide them," according to Kathryn Judge, a professor at the Columbia University School of Law who this year published a working paper titled "Information Gaps and Shadow Banking."

Judge echoes Josse's sentiment that shadow banking is not inherently a risky activity — in fact, she says shadow banking seems to spook people just because of its name alone. But she says the lack of a central body overseeing such activities is an issue.

Shadow banking serves an important "social welfare" function in the economy, Judge said, but is not accurately measured in a way that can offer the general public a comprehensive picture of just how much money is involved in the flow of shadow banking and shadow credit.