Rise of shadow banking a victory for consumers

Hedge and private-equity funds, mortgage lenders, and money-market funds provide accessible sources of credit

By Paz Gómez
Research associate

Frontier Centre for Public Policy

Shadow banking is growing by leaps and bounds in Canada. It’s a C$1.5-trillion industry that expanded by 30 per cent between 2015 and 2017, according to a recent Bank of Canada report.

The banking establishment fears a challenge to its power, but consumers benefit from greater access and affordability.

Among those sounding the alarm are Jeremy Kronick, an associate director with the C.D. Howe Institute, and Wendy Wu, an economics professor at Wilfrid Laurier University. In an opinion piece for the Financial Post, they claim shadow banking – also called non-bank financial institutions – has become “too big to ignore” and is undermining “the effectiveness of monetary policy.”

Its growth, however, is welcome. It’s the logical result of undue regulatory burdens on the banking system, which translate to arbitrage opportunities. Canadians are flocking to more competitive, accessible alternatives to lend and borrow money, such as investment funds, insurance firms, mortgage and payday lenders, and peer-to-peer systems.

While acknowledging shadow banking raises economic efficiency through dis-intermediation, technology and regulatory arbitrage, Kronick and Wu argue they pose a systemic risk.

They argue Canada weathered the 2008 financial crisis in part because this sector was relatively small. In contrast, in the United States, large shadow bankers have been offering subprime mortgages and loan security since the early 2000s.

From the perspective of regulators and central banks, shadow banking’s main threat lies in their inability to use it as a policy-making lever.

Kronick and Wu explain these institutions split conventional banks’ functions into different unregulated and uninsured entities. For instance, one might operate a mutual fund that buys shares in a company that in turn lends to Canadians.

Moreover, their research indicates that the larger the sector, the less impactful are policies aimed at controlling the money supply. For example, when the Bank of Canada raises interest rates, providing credit becomes more expensive for traditional banks – but less so for shadow banks.

The unintended side effect is encouraging shadow-banking growth, which in turn lessens the power of future government actions.

Shadow banks are an important source of funding for the economy. Hedge and private-equity funds, mortgage lenders, and money-market funds provide accessible sources of credit.

They turn risky assets into liquid securities through investment funds, dealer-repurchase agreements and asset-backed commercial papers. During good times, these instruments come close to cash.

American finance professors Alan Moreira and Alexi Savov argue the consequent liquidity expansion lowers capital costs for firms and individuals, spurs greater investment, and leads to higher economic growth. Shadow banking can also benefit sustainable development, since it “moves up the risk-return frontier, funding riskier but more productive investments.”

They don’t deny shadow banking poses a potential systemic risk when times get rough. These institutions make riskier assets more affordable but also reduce good collateral in the economy.

A 2017 study from the Stanford Graduate School of Business portrays shadow banking as a clear winner of the 2008 financial crisis. As U.S. regulators clamped down on banks, shadow lenders filled the gap by serving customers with riskier credit scores. The study shows shadow lenders have larger market shares in U.S. counties with high unemployment, low median incomes and large minority populations.

Stanford researchers estimated that regulatory advantages over traditional banks accounted for 55 per cent of shadow banking’s growth from 2007 to 2015 in the United States. Customers are apparently making less red tape a priority.

That’s not to say shadow banking is the wild west of financial markets. After the recession of the late 2000s, the U.S. federal government increased scrutiny on the institutions. The European Union, China and other countries followed suit.

But it’s now a US$51.6 trillion industry, accounting for 14 per cent of the world’s financial assets.

In 2017, G20 nations – including Canada – requested an assessment of shadow banking’s evolution and policy performance post-2008 from the Financial Stability Board (FSB), a Swiss-based monitoring organization. It found shadow banks have significantly improved those aspects that contributed to the late-2000s recession.

Nevertheless, it identified an increased liquidity risk in certain investment funds that offer daily redemptions but hold hard-to-sell assets. In a crisis, that can lead to a market plunge as investors scramble to liquidate their positions. It recommended G20 nations continue monitoring and enhancing oversight.

While C.D. Howe Institute researchers recommend bringing shadow banks into the banking system – extending regulations, deposit requirements and insurance – they can still play an important liquidity role outside of it.

The missing element is a financial authority that steps in during extreme circumstances to buy up risky assets and provide safe ones under the promise of repurchasing them later. Since this can expose the government to losses, regulators wouldn’t intervene unless it becomes imperative.

Making shadow banks look more like banks negates their competitive advantage to the benefit of large incumbents. Shadow banking has flourished precisely when central banks and financial authorities slow down credit with excessive regulation. It provides the economy with much-needed liquidity, encourages more productive investments and stimulates growth.

Striking a balance between scrutiny and freedom for shadow banks will continue to benefit consumers and the private sector.

Paz Gomez is a research associate with the Frontier Centre for Public Policy.

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