(Bloomberg View)—Taxi companies that compete with Uber and media companies that are up against Facebook know it: In a rivalry between regulated and unregulated firms, the latter have an unfair advantage. It also applies to banks, which spent the past ten years losing market share to companies that regulators ignored.
QuickTake Shadow Banking
In a fresh working paper, Greg Buchak and Gregor Matvos of the University of Chicago, Tomasz Piskorski of Columbia Business School and Stanford's Amit Seru calculated that between 2007 and 2015, so-called shadow banks have increased their share of the U.S. Federal Housing Administration mortgage market sevenfold to 75 percent. That's the market where the less creditworthy borrowers get their loans. In the U.S. mortgage market as a whole, shadow banks held a 38 percent share in 2015, compared with 14 percent in 2007.
In other markets, financial organizations that are not subject to bank regulation have flourished, too. According to the Financial Stability Board, the august body that makes recommendations to the global financial system from Basel, Switzerland, "other financial intermediaries" -- the category that includes non-bank lenders but not insurance companies and pension funds -- increased their assets to $80 trillion, or 23 percent of total financial assets, in 2014. Their average growth reached 5.6 percent in 2011 through 2014, while the global banking system's assets stopped growing during that time.
In any discussion of shadow banking's size, definitions are important. To the FSB, shadow banks are a subset of "other financial intermediaries" with about 12 percent of total banking assets in 2014. The body puts only the riskiest firms in this category -- those that are especially susceptible to runs or dependent on short-term financing. To researchers such as Buchak and his collaborators, the definition is broader: All non-bank lenders that "conduct credit, maturity and liquidity transformation without direct, explicit access to public backstops." Such backstops include direct refinancing by a central bank or deposits protected by government deposit insurance.
Despite leading to astronomical risk assessments, the FSB methodology makes shadow banking look smaller than it actually is. For policymakers, risk is perhaps the most important element of the massive drift of financial activity from banks to other types of firms. But it's not the only one that matters -- at some point, millions of pages of banking regulations around the world could become useless if the financial sector decides to avoid working through entities that can be defined as banks. In a crunch, tens of millions of people may be left unserved because no one will bail out the unregulated financial operators or pick up their business.
The reason shadow banks have largely escaped public scorn, regulatory scrutiny and high capital requirements is that they often came in the guise of high-tech disruptors. Quicken Loans Inc., the third biggest mortgage lender in the U.S. in 2015, does business online and on the phone, and that somehow makes it less interesting to regulators than a bank that does the same through an old-style branch network. Lending Club and other "peer-to-peer" lending firms quickly became conduits for large investors, not "peers," yet they avoided regulation as though they were innovative tech platforms.
Buchak and his collaborators built a model to parse the growth of shadow banks since 2008. Using it, they calculated that 55 percent of the growth is explained by the increasing regulatory burden on banks, and only another 35 percent by technological advances. These advances are undeniable, mainly in terms of convenience to clients. If anyone expected tech firms could be more efficient in figuring out credit risks using big data, that's not happening yet. According to the Buchak paper, the mortgages originated by shadow banks default a little more often than those issued by banks. More importantly, they carry a significantly higher risk of early repayment.
In any case, banks, which could have used the same technology to compete, weren't only held back by their obsolete mindset and the drag of "legacy" expenses on nostalgic infrastructure. Just as the fintech disruptors developed their platforms, banks were hit with huge restructuring and legal costs and, simultaneously, with demands for new capital.
Buchak, Matvos, Piskorski and Sero wrote:
Traditional banks have slightly lower shadow cost of funding and provide higher quality products than shadow banks. Despite this, they lose market share during this period because of a large increase in the intensity of regulatory burden after 2010 passage of the Dodd-Frank Act.
In addition to the increasing regulatory burden on banks, the U.S. government has helped shadow banks in another important way: By 2015, 85 percent of the mortgages they originated was sold to government-sponsored enterprises such as Fannie Mac, Ginnie Mae, Freddie Mac and Farmer Mac. They benefit from implicit and explicit government guarantees originally supplied to banks -- without shouldering the same regulatory burden or facing the same stigma. In other words, they profit from regulatory arbitrage.
Perhaps the traditional bank model is doomed, and regulators are trying to help it die. But the alternative isn't necessarily better, especially for the average saver, who, if traditional banks gradually recede into history, will be stuck with riskier investment opportunities than today.
It's probably unrealistic to expect major easing of banks' regulatory burden. Governments, however, could level the playing field by deciding that any lender is a bank and imposing the same tough rules on all of them. Regulatory arbitrage is inherently unfair, and it's unclear why firms that claim a technological advantage should be given additional preferences.
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