Rise of Shadow Banking is Victory for Consumers

Commentary, Economy, Paz Gómez

Competitors Mean Less Power for Incumbents, Central Bank

Financial intermediation outside the banking system, also known as shadow banking, is growing by leaps and bounds in Canada. It is a CAD$1.5 trillion industry that expanded by 30 percent between 2015 and 2017, according to a recent Bank of Canada report. Whereas the establishment fears a challenge to its power, consumers benefit from greater access and affordability.

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

Its growth, however, is a welcome development. It is 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.

A Growing Problem for Central Bankers
While acknowledging shadow banking raises economic efficiency through disintermediation, technology, and regulatory arbitrage, Kronick and Wu argue NBFIs pose a systemic risk. They argue Canada weathered the 2008 financial crisis in part because the NBFI sector was relatively small. In contrast, in the United States, large shadow bankers were offering subprime mortgages and loan securitization 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 policymaking lever.

Kronick and Wu explain NBFIs split conventional banks’ functions into different unregulated and uninsured entities. For instance, one NBFI 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 NBFI 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 NBFIs. The unintended side effect is encouraging shadow-banking growth, which in turn lessens the power of future government actions.

The Unseen Benefits of Shadow Banking
NBFIs 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 illiquid assets into liquid securities through investment funds, dealer-repurchase agreements, and asset-backed commercial papers. During good times, these instruments come close to cash.

According to Yale University finance professors Alan Moreira and Alexi Savov, 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 argue.

They do not deny shadow banking poses a potential systemic risk when times get rough. NBFIs make riskier assets more affordable but, at the same time, reduce good collateral from the economy.

From a different angle, a 2017 study from Stanford’s Graduate School of Business portrays shadow banking as a clear winner of the 2008 financial crisis. As US 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 US counties with high unemployment, low median incomes, and large minority populations.

Stanford researchers estimated that regulatory advantages over traditional banks accounted for 55 percent of shadow banking’s growth from 2007 to 2015 in the United States. In other words, customers are prioritizing less red tape.

Targeted Intervention, Not Blanket Regulation
That is not to say shadow banking is the Wild West of financial markets. After the Great Recession, the US federal government increased scrutiny on NBFIs. The European Union, China, and other countries followed suit. Nowadays it is a USD$51.6 trillion industry, accounting for 14 percent 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. The FSB found NBFIs have significantly improved those aspects that contributed to the Great Recession.

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

The trade-off between financial stability and economic growth vanishes with the right approach.

Whereas C.D. Howe Institute researchers recommend bringing NBFIs into the banking system—extending regulations, deposit requirements, and insurance—Moreira and Savov show they can still play their 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 re-purchasing them later on. Since this can expose the government to losses, regulators would not intervene unless it becomes imperative.

Making NBFIs 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 NBFIs will continue to benefit consumers and the private sector.

 

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