Non-Bank Banking–Shadow Banking Systems: Changing Shape of Financial Intermediation and Banking Regulations…

Non-bank banking system or shadow banking system can broadly be described as– credit intermediation involving entities and activities outside the regular banking system… in short, non-bank financial intermediation…

Non-bank banking: What exactly is non-bank banking? Government agencies expend a lot of time and money coming up with definitions. These exercises might seem silly until a seemingly obvious term like, ‘bank’ gets caught up in some sort of regulation, civil action, enforcement… Then, the official definition suddenly becomes a serious matter… A current example concerns the term ‘non-bank banking’, which has become important since the federal law now authorizes the Consumer Financial Protection Bureau (CFPB) to supervise large banks, thrifts, credit unions… i.e., non-banks.

According to Marcie Geffner; to carry out supervision, the CFPB must figure out which firms qualify… A working definition on CFPB website suggests that– firms offering financial products-services to consumers without; bank, thrift, credit union charter, and that don’t take deposits– qualify as a ‘non-bank banking’. Broadly speaking that includes; payday lenders, student loans, debt collectors, credit reporting, mortgage banking… Non-banks simply intermediate transfer of funds from the bank accounts of original investors to the bank accounts of the ultimate borrowers… they act as conduit between those with funds to lend and those in need of funds.

According to ‘economist’; fixing one problem often creates another. The financial crisis has produced a wave of regulation to make the banking system safer, but that opened the door to other providers of non-bank finance… At one end of spectrum, peer-to-peer lenders are experimenting with entirely new forms of finance in which individual savers and borrowers are matched in electronic marketplaces. At the other end, the world’s biggest insurers and asset managers are building up credit-analysis capabilities so that they can lend money directly to mid-market companies, infrastructure schemes, property developments…

The banks are often partners in the process, originating debt and then passing it on to institutional investors. The idea that more funding activity will pass from banks to non-banks makes many people queasy. The term shadow banking is often used to conjure up– dark world of non-bank banking firms. But, like regular banks, shadow banks provide credit and generally increase the liquidity of the financial sector. Yet unlike regulated banks, they lack access to central bank funding-safety nets, such as; deposit insurance, debt guarantees… However, due in part to specialized structure, shadow banks can sometimes provide credit more cost-efficiently than regular banks.

Many shadow non-bank firms have emerged and are playing an important role in providing credit across the financial system. In U.S. and prior to the 2008 financial crisis, shadow banking system had overtaken the regular banking system in supplying loans to various types of borrower, including; business, home and car buyers, students, credit users… According to Paul Krugman; the shadow banking system is the ‘core of what happened’ to cause the crisis… He referred to this lack of controls as ‘malign neglect’. One former banking regulator has said that– regulated banking organizations are themselves the largest shadow banks, and shadow banking activities within the regulated banking system were responsible for the severity of the financial crisis…

In the article Rise of Non-Bank Credit: Revolution or Evolution? by KPMG writes: Traditional bank lending continues to be constrained by tighter regulation, increased capital requirements and a more conservative approach to risk. This would appear to open up significant business opportunities for alternative sources of credit, but there are a number of factors that may hinder the much-heralded revolution in credit provision.

The global scale of bank lending is so large that if banks retrench their activities by even a few percentage points, it opens-up a significant market for non-bank lenders. But if there are any concerns about a potential explosion in non-bank lending leading to another credit bubble, these should be balanced against the countervailing constraints: The market is globally fragmented, barriers to entry can be high, and it’s hard to identify and implement the right business model for the right market. For example, differences between Europe, North America and Asia are stark. In Europe, the traditional model of bank lending dominates the market – and indeed the culture– of many countries… In the UK, retail and small and medium enterprise lending is dominated by the banks.

Access to credit in the UK is perceived to be difficult and, in an effort to free up alternative financing, the government is effectively sponsoring new entrants… In North America, by contrast, there is a mature non-bank lending sector from community banks to micro-lenders to accounts receivable financing to peer-to-peer or social lending, and it would appear this increased diversity is one of the reasons why the supply of credit is not such an issue in the U.S. as it is in Europe…

Asia with its growing export-led economies has no lack of local currency liquidity and there is not the same tension as in Europe with regard to retail and business lending– the strategic focus is on funding the big-ticket items like, China’s numerous infrastructure projects…

However, rapid economic growth has also led to a significant expansion of non-bank lending in China… We are entering an era of opportunity for alternative credit. Just as in the past, we have seen the leasing industry flourish as firms looked for more flexibility in their use of capital, and securitization boom as banks seized the opportunity to free up their balance sheets, now there is an opening for non-bank lending to achieve a step change.

But success for a new entrant is not a given and it only come from a clear understanding of their own business model– and how flexibly it can be shaped to meet local needs of markets, regulators and customers. In the end, what we may be witnessing is not so much a revolution, but evolution in non-bank banking.

In the article Shadow Banking Out Of Shadows by ‘financialtimes’ writes: The threats posed by shadow banking are not hard to understand. The sector is rife with sources of instability. Much of the leverage in the U.S. economy grew outside bank balance sheets through securitized loans; networks of derivatives involving non-bank firms amplified systemic risk… As regulators constrain banks’ room for maneuver, they must beware of risky behavior merely migrating to the shadow banking sector where it will be harder to spot.

Other threats flow from the connections between the ‘lit’ and ‘shadow’ side of finance. Banks have long relied on shadow banking (non-bank banking) by borrowing from money market funds in repo markets. Risks that might be acceptable outside the banking system can become systemic by exposing conventional banks to disruption. But with wise policy, usefulness of shadow banking activities can be greater than threats. Taming and harnessing non-bank finance rather than smothering it should be the goal of rule-makers.

There is advantage to having alternatives to conventional banks. It’s not coincidental that U.S.– where ‘banks’ intermediate less of financial flows than in UK or euro-zone– is further ahead in recovery: If all financial plumbing is routed through banks, you have a much worse problem when pipes clog up– as Europe is now learning the hard way. Non-bank banking can also offer healthy competition in markets where normal banking is dominated by a few big names.

And there are various types of financing with risk and maturity profiles more suited to equity-like relationships than conventional loans: For example, banks should steer clear of entanglement in the payment system, deposit account provision… Also, the risk that consumers treat money-market funds much like insured deposits… This must either be counteracted or the funds must face equivalent rules to deposit-taking banks.

Similar decisions must be made in many other cases. If financial regulations don’t spread the ‘light’ of risk wider-brighter, it will only drive more risk into ‘shadows’… Non-bank banking should complement the business of banks– not substitute for it– they must not be banks with just another name, without regulation…

In the last five years, few industries have changed as rapidly as the banking industry. Once viewed as stodgy and conservative, banks have become increasingly aggressive and competitive. Banks and non-bank banking businesses have expanded both their financial services and geographic markets. Despite these changes, Congress, perhaps influenced by lobbyists, has not reformed old bank laws to meet market conditions. Consequently, federal courts-regulators have had difficulty applying dated laws to recent developments.

One such law is the ‘Bank Holding Company Act (BHCA). The BHCA defines a ‘bank’ as any institution organized under state or federal law that meets both parts of a two-pronged ‘bank’ test: (1) accepts deposits that the depositor has a legal right to withdraw on demand, (2) engages in the business of making commercial loans. In recent years, banks have avoided regulation under the BHCA by acquiring financial institutions that do not meet one of the two prongs of the ‘bank’ test. These new financial hybrids, which often offer most other types of banking services, have become known as ‘non-bank banking’… The non-bank banking (i.e., shadow banking) global industry has grown to about $67 trillion; leading global regulators to seek more oversight of financial transactions that fall outside traditional oversight…

The ‘Financial Stability Board’ (FSB), a global financial policy group composed of regulators and central bankers, found that shadow banking grew by $41 trillion between 2002 and 2011… The Dodd-Frank Act provides some provisions towards regulating shadow banking systems by stipulating that the ‘Federal Reserve System’ would have the power to regulate all institutions of systemic importance… There are concerns that more businesses may move into the shadow banking system as regulators seek to bolster the financial system by making bank rules stricter… However, the good news is that despite the dismal credit environment, there are many non-bank financing options available to companies that need a cash infusion, whether to beef-up working capital or help facilitate growth.

The bad news is that business management often shy away from non-bank or alternative financing because they don’t understand it. Most automatically rely on their banker for financial information and many bankers (not surprisingly) have only limited experience with options beyond those offered by the bank… The message is simply; ‘financially challenged’ companies should not be afraid to consider alternative or non-bank financing options. It’s a fairly simple matter to learn– what they are, how much they cost, how they work– then companies would be in a better position to decide if they are the answer to their financing challenge…

Even more, according to the Deutsche Bank; conventional banking could soon become a thing of the past with the use of the Internet and mobile devices booming. Following a technological revolution in payments, web services could take the next steps by developing their own applications for allowing credits-making deposits... Also, traditional banks will be challenged by new rivals, like; Google, Apple, Amazon, Paypal… who are developing Internet applications to effect mobile payments…

According to Elizabeth Warren; it’s time for serious oversight of non-bank lenders like; mortgage brokers, payday loan outfits… to protect consumers from abusive practice of these largely unregulated businesses…