Hoover Fellow Warns About “Shadow Banking” Threat

“Shadow banks” are capable of the kind of reckless mortgage lending that led to the 2008–09 financial crisis, a Hoover Institution scholar says.

Like regular banks, shadow banks lend money to consumers, but these banks are not subject to as many regulations. For example, they do not use bank deposits to finance lending.

The problem is that lightly regulated shadow banks have grown as the residential mortgage market has changed in the years following the Great Recession, according to Amit Seru, a Hoover Institution senior fellow who has co-authored two working papers on the subject: “Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks” and “The Limits of Shadow Banks.”  

In fact, this type of lending has escalated from roughly 30 percent of all US lending in 2007 to 60 percent in 2017, according to Seru’s research. The primary reason for this migration of lending is that regulations on shadow banks are limited, though superior technology in shadow banks has also played a role. Such banks now provide about 75 percent of all loans to low-income recipients, and one concern is that these lenders may grant loans to risky borrowers with lower incomes and poor credit scores.

That is a troubling trend, Seru wrote, because shadow banks are significantly more dependent on federal guarantees than traditional banks. In fact, these lenders immediately resell almost all the loans they make, with the bulk—almost 90 percent—sold to government-run entities like Freddie Mac and Fannie Mae. So, if the borrowers can’t ultimately make their loan payments, US taxpayers are on the hook for loans made by shadow banks.

Moreover, shadow banks originate and warehouse loans before they are sold using short-term lines of credit from traditional banks, he said. Any deterioration in the quality of loans made by shadow banks before the loans are sold will therefore ripple back into the traditional banking sector.

Policy Implications

The research findings have a number of implications, according to Seru:

• Because lending activity migrates between banks and shadow banks, a complete policy analysis of the lending market critically requires simultaneously analyzing the impact of the policy on both traditional banks and shadow banks. “Policy and regulatory changes cannot be considered without a full view of the market equilibrium.”
• The line between traditional and shadow banks from a functional perspective is not clearly determined, but migration of lending to and from shadow banks is affected by the capitalization of banks and the banking sector.
• Because shadow banks do not have the ability to keep the loans on their balance sheet, these banks are heavily dependent on the presence of the securitization market. Unfortunately, private securitization is absent, and therefore shadow banking activity is intrinsically tied to securitization provided by the GSEs. (A GSE is a government-sponsored enterprise or financial services corporation created by the US Congress.)
• Traditional policy tools such as capital ratios and other bank capital regulatory requirements, unconventional policies such as quantitative easing (QE), and other housing policies like changed conforming limits may not have the desired consequences due to their effects on shadow banking.

Seru and his co-authors suggest regulators take a broad view of government insurance subsidies and regulation to truly understand their effects on the financial system.

“On the one hand, traditional banks exploit cheap insured deposit financing. On the other, shadow banks and poorly capitalized banks predominantly use GSE (government-sponsored enterprise) insured mortgages,” Seru and his fellow researchers wrote.

The research shows that as subsidies for banks in one sector decline—for example, because of restrictive capital requirements—these lenders tilt their activity toward other sources of taxpayer-financed subsidies, he said.

Such policies may not impact shadow banks as much, according to Seru. On the other hand, subsidies in the GSE securitization market, such as conforming loan limits or QE, could lead to significant changes on the shadow banking side and also impact the banking sector through competitive interaction with shadow banks. The overall impact on the financial system—including both shadow banks and traditional banks—therefore requires a more nuanced analysis, he added.

The bottom line, wrote Seru, is that “understanding the web of subsidies and regulations that pervade the financial system, their equilibrium interactions, and their impact on systematic risk and welfare remains a fruitful area for future research.”

Regulatory Arbitrage and Technology

When traditional banks contracted in markets where they faced more regulatory constraints, shadow banks partly filled these gaps, Seru said.

The term “fintech,” a portmanteau of “financial technology,” is used to describe new technology that improves and automates the delivery and use of financial services. ​​​This rapid online approach to mortgage lending has also contributed significantly to the shadow bank explosion, Seru’s research found.

Overall, the research shows that regulation accounts for roughly 60 percent of shadow bank growth, while technology accounts for roughly 30 percent, the studies found. 

Looking Ahead

Although it is difficult to predict how and when the next crisis will strike, Seru said that if banks—both traditional and shadow—continue to exploit subsidies to take dangerous risks, then economic calamity is likely. 

While the issue of how and which subsidies to get rid of is complex, adopting one simple solution would do a lot of good in reducing the likelihood of a crisis, Seru said. This solution would involve requiring all banks—traditional as well as shadow banks—to keep larger equity capital buffers, so the banks can survive traumatic financial shocks and thereby prevent cascading effects across the global economy.

In addition, he noted, policies that jump-start the private securitization market would also lead to movement of risk—particularly from shadow banks—from so-called ‘too-big-to-fail’ taxpayer funded GSEs—to private investors.

Although the policies just described could prove very useful before the crisis hits, Seru said the type of mortgage contracts that are offered could dampen the impact when a crisis does occur. “State-contingent” mortgage contracts would automatically index a borrower’s interest rate to vary with local economic conditions. During a crisis, this solution would automatically decrease foreclosures and improve the financial health of consumers, thus serving as an automatic stabilizer and better protecting the entire economy, Seru said.

MEDIA CONTACTS:

Clifton B. Parker, Hoover Institution: 650-498-5204, cbparker@stanford.edu