Shadow banking is growing fast -- is that a threat?

Shadow banks: The name sounds sinister, and these lightly regulated lenders do get some of the blame for the 2008-09 financial crisis. But they’re becoming an increasingly important feature of the global financial landscape, to the dismay of critics who fear they’ll eventually produce another financial systems failure.

Also known more benignly as nonbank lenders, these entities have expanded their reach to almost $18 trillion in assets (mostly loans), according to Keefe, Bruyette & Wood (KBW), an investment firm that specializes in the financial services industry.

That compares to just over $16 trillion for commercial banks like Bank of America (BAC) and JPMorgan Chase (JPM), which are covered by the Federal Deposit Insurance Corp. and overseen by regulators like the Office of the Comptroller of the Currency. Most shadow banks have zilch to do with the FDIC and the OCC.

And the shadow banks have been growing faster. In 2016, their assets expanded 5 percent, compared to 2 percent for commercial banks, KBW figures. This marks a solid recovery because, like everyone else in the financial industry, the crisis damaged shadow banks badly. Their assets were as high as $21 trillion in 2007. 

But nowadays they have an advantage that has accelerated their rebound: Partly because shadow banks don’t have depositors, they operate in a less-restricted world. While commercial banks have stepped up their lending in the wake of the Great Recession, they’ve also tightened lending standards, especially for mortgages and auto loans. 

That has created an opportunity for the shadow banks. Commercial banks “don’t want to be in subprime mortgages,” said Frederick Cannon, KBW’s global director of research. Instead, traditional banks prefer so-called “jumbo” loans, which in most states means above $424,100.   

Wouldn’t this picture change if the Trump administration rolls back regulations, such as the Dodd-Frank law, which reins in commercial banks from pursuing riskier activities? Perhaps, but a return to the wild and woolly days before the crisis, when everyone was granting credit with abandon, seems unlikely, at least anytime soon. Also, it’s possible that Dodd-Frank will be pruned, not eliminated. 

The argument: Despite President Donald Trump staffing his policy team with Wall Streeters, congressional Democrats and a number of Republicans will act as a brake on the total destruction of Dodd-Frank. And they’ll be sure to remind Mr. Trump of his anti-Wall Street campaign rhetoric. “This is the second inning of a nine-inning regulatory rebalancing,” Richard Hunt, who runs the Consumer Bankers Association, a group that represents retail banks, told Bloomberg News. 

Meanwhile, any smaller paring of government rules, though an important boost for traditional banks, also will benefit shadow lenders because they can more easily borrow from those banks, a new report by KBW indicates. Separately, shadow banks are buoyed in another way: The yields for corporate bonds have come down, due to a brighter economic outlook -- helping nonbanks that raise capital by issuing bonds. 

As a result, shadow banking stocks have been rising along with other financial shares since the election. For this year through last Friday, KBW said, they’re up 6.1 percent, while the S&P financial sector index climbed 7 percent.  

The shadow banks encompass a wide range of activities. The most prominent is mortgage lending. In 2015, the last year available, nonbank lenders made up 48 percent of all mortgage activity, S&P Global Market Intelligence calculates. That was up from 45 percent the year before. The biggest players are Quicken Loans, loanDepot.com and Freedom Mortgage.

But the designation of shadow bank also ropes in a disparate array of financial companies that include money market funds, life insurers, consumer and business lenders. It’s not that these companies face no regulation. Insurers, for instance, are supervised by state regulators and must meet their underwriting standards for policies. And just like Bank of America does, nonbank lenders also have to obey Dodd-Frank edicts on suitable lending, such as ensuring that prospective borrowers are solvent enough to pay off loans. 

Here’s what you should know about the increasingly potent force of shadow banking: 

The risk: Shadow banks appear solid now, but they did before the crisis, too. The very size of the shadow banks is what worries some economics experts. In 2007, things looked auspicious for them, especially the mortgage lenders. Then the floor disintegrated.

One skeptic is Federal Reserve Vice Chairman Stanley Fischer, who last fall at the Institute of International Finance conference in Washington, D.C., said “I worry a little bit about the fact that we in the United States do not have very good mechanisms for dealing with the nonbank sector, the shadow banking system,”   

With weaker regulation than traditional banks labor under, Fischer and others fear, the temptation may be too much for nonbank lenders to get into risky endeavors that promise tasty returns. “Shadow banking provides a useful service to society,” wrote Daniel Sanches, a senior economist at the Philadelphia Federal Reserve Bank. “The problem is that, under certain circumstances, these financial institutions can become fragile -- that is, subject to panics.” 

Bill Gross, now a fund manager at Janus Capital Group, warned two years ago in his letter to clients that while “Dodd-Frank has made actual banks less risky, the risks have just been transferred to somewhere else.” Namely to shadow banks, and he points to his former employer, fund giant Pimco, and Metlife (MET), the insurer.

The prime cautionary tale is Lehman Brothers, which in its day was the epitome of a shadow bank. With scant regulatory oversight, this investment firm plunged into risky subprime mortgages and sank deep into debt. Lehman had a peak market value of $60 billion and $600 billion in assets -- a mere 18 months before it collapsed. When it fell apart, it was the fourth-largest U.S. investment bank and became the largest bankruptcy in U.S. history.  

Following Lehman’s failure, other Wall Street titans -- like Goldman Sachs (GS) and Morgan Stanley (MS), nonbanks all -- teetered on the edge of disaster, and the world financial order along with them. A whole array of nonbank mortgage lenders went down the chute, like New Century Financial. 

The government and the Federal Reserve saved the system with bailout funding and by designating the Wall Street giants as bank holding companies, thus subject to federal protection. And although Wall Street firms have repaid the money and shucked the bank mantle, Washington still considers them “systemically important financial institutions,” meaning capable of damaging the financial system and therefore still subject to federal oversight.

The bright side: After the 2008 trauma, appetite for risk among shadow banks isn’t high. The profligacy of the 1920s gave way to the hard times of the Great Depression. Those rueful memories made consumers and businesses more prudent, even during the post-World War II prosperity. That was one of the findings in newsman Tom Brokaw’s book, “The Greatest Generation.” This group, he wrote, “knew that going into the debt was not the way to get the things you want.”

The same spirit seems to pervade many shadow bankers lately. Consider CIT Group (CIT), founded 109 years ago to provide financing and leasing to middle-market companies. For years, it prospered by offering such services as immediate financing to retailers, secured by invoices for upcoming deliveries, known as factoring. Then around 2004 it hopped into subprime mortgages. The result was a debacle that led CIT to get designated as a bank, receive bailout cash and declare bankruptcy. 

These days, CIT is out of the home loan business and is shedding its unit that buys and leases airplanes, an enterprise that ties up capital. In 2015, it bought OneWest Bank -- from an investment group that included Steven Mnuchin, now the U.S. treasury secretary -- and plans to focus on being a commercial lender. Today, 68 percent of its funding comes from bank desposits, and after the aircraft divestiture closes, it will be 75 percent.

The same situation pertains at Ally Financial (ALLY), formerly known as GMAC, which was the auto financing arm of General Motors (GM). During the housing bubble, just like CIT, it set up a mortgage lending unit, to its eventual grief. To avoid doom, it also became a bank and accepted bailout bucks. 

These days, the since-renamed Ally has an online bank (of the traditional, FDIC-protected variety) and insurance and wealth-management subsidiaries that aren’t part of the bank. No longer a division of GM, it furnishes auto financing to dealerships from all brands. “Ally has been dramatically transformed,” said Diane Morais, who heads its consumer commercial banking products.

At the same time, some shadow banks never went too far out on the risk curve. Prime example: business development companies, which buy loans to midsize businesses. BDCs, which have publicly traded shares, function under the 1940 law that also governs mutual funds. Legally, the amount of debt on a BDC’s balance sheet may not exceed its equity. A segment of BDCs that concentrated in energy suffered in the recent oil downturn, but overall the BDC category came through the financial crisis largely unscathed. 

Perhaps shadow banking has a bright future after all. Let’s hope that’s true.

  • Larry Light

    Larry Light is a veteran financial editor and reporter who has worked for the Wall Street Journal, Forbes, Business Week, Money, AdviceIQ and Newsday.