Bridge over ocean
1 August 2014 CFA Institute Journal Review

Shadow and Substance (Digest Summary)

  1. Marc L. Ross, CFA

In the wake of the financial crisis, shadow banking has grown as banks have faced regulations on their lending practices.

What’s Inside?

Many activities that traditional banks have handled in the past now face competition from shadow banks. Banks have been reeling from the financial crisis and new regulation designed to prevent another crisis.

How Is This Article Useful to Practitioners?

The recent financial crisis deeply affected traditional banks. Now, competing with them in numerous areas are “shadow banks,” which are institutions that perform many of the same functions as banks but with less regulation. Accordingly, these types of companies are less constrained in what they can provide to businesses and how they can provide it.

Shadow banking initially had a bad reputation because its attempts to expand credit and dissipate risk actually created less valuable, riskier products. Designed to isolate the risks of securitized loans, off-balance-sheet or special purpose vehicles carried risks that were ultimately borne by the banks that established them, with disastrous results during the financial crisis. Adding to these banks’ travails were money market funds, which are also shadow banks with ostensibly no risk. When one of these funds “broke the buck,” a domino effect ensued. With the financial troubles in their special purpose entities, banks were unable to access short-term capital to pay creditors and depositors. Taxpayers ended up paying for the bailout to try to prevent the entire financial system from crashing.

As a result of these troubles, banks now can increase capital only by raising it (by way of stock and bond issuance), cutting costs, or decreasing lending and investment. Increased capital retention requirements and more stringent asset/liability matching have resulted in less business lending and as a consequence, shrinking balance sheets.

Shadow banks are now stepping into the void. These are often institutional investors, such as pension funds and insurers with “skin in the game,” that lend directly to a business in the form of private placement (private debt). These investors bear the risk directly with no assistance from the taxpayer. In the United States, there are business development companies that perform a similar function and that have grown tenfold in the past decade. Financial disintermediation is taking on a greater role as well. Corporate bond issuance has increased as well as peer-to-peer lending, which involves matching lenders and borrowers through the internet.

Banks are suffering in such other areas as payments (e.g., credit or debit cards), with competition coming from “virtual wallets” and electronic currency arrangements. Banks’ trading activities have taken a hit as well. Large customers are wanting to trade directly between themselves. Finally, banks’ role in asset management has declined, often because of conflicts of interest, but also as a result of the need to raise money in the wake of the recent crisis.

Abstractor’s Viewpoint

The evolution of financial markets has proceeded at a steady pace in the United States for a long time, but it is also taking hold in Europe. Areas of capital provision once reserved for traditional lending institutions are now being offered by shadow banks that can move more nimbly and are less regulated. Although banks will not go away, the roles of financial institutions will continue to evolve.

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