Why So Much Affection for Shadow Banking?

I am not easily astonished, but I have to confess astonishment at the nostalgic affection for shadow banking. 

Even while professing deep fondness for commercial banks, particularly for community banks, shadow banks'impresarios have publicly offered numerous schemes for expanding shadow business at the expense of the commercial banking industry.  Rising above the great variety of the plans is a unifying characteristic:  All would deliver a mighty stimulus to the shadow banking world and accelerate the decline of commercial banking.

The latest new idea is really an old idea (as are nearly all of these "new" ideas):  To have another go at the 1990s experimental concept of the narrow bank, a bank that does nothing more than "traditional banking." 

Laying aside for now the daunting challenge of defining what is "traditional banking"—a challenge demonstrated by the eight years it took the SEC and the bank regulators to define traditional bank securities products—narrow banking means a narrow industry. 

Where do all the things go that banks do profitably today that will not be blessed as being "traditional banking"?  They will not disappear as long as these are products and services that customers will pay for.  Shadow banking will happily take them.

Keep in mind that shadow banks are already doing as much banking as they can—hence their handy moniker.  There is very little that a bank does today that does not face competition from nonbanks, except maybe paying for deposit insurance and supporting heavy regulatory supervision.  There are plenty of nonbanks making loans, providing deposit-like products, and offering payment services, but for now they do have to compete with banks for their customers. 

Under the narrow bank schemes, nonbanks will still be able to do pretty much all that banks do as well as offer all of the products and services that banks will no longer be able to offer.  Narrow banking eliminates a big part of the competition.  That suggests narrow banks will become progressively narrower as their earnings are eroded and more customers find their way to shadow banking’s doors.  

Some narrow bank regimes would allow holding companies to offer—in affiliates walled off from the bank—what might not meet the "traditional banking" definition.  Perhaps some banking firms would be able to afford capitalizing, establishing, and running more nonbank affiliates to do that and somehow work out the regulatory and business hurdles to offering combined services.  With such affiliations, though, size matters, and many banks may find that ability a strain.

The proffered favors to shadow banking are particularly puzzling, considering that the recent financial recession had its prime locus among shadow banking firms, which proved to have feeble defenses against the winds of adversity.  Remember the fallen: Bear Stearns, Lehman Brothers, AIG, Fannie Mae, Freddie Mac, and Merrill Lynch, along with thousands of lesser-known nonbank financial businesses. 

This is not to ignore that there were commercial banks (large and small) that eventually failed or got into financial trouble, too, some in part in their efforts to pick up the pieces of the failing nonbanks.  The point is that the shadow banking firms were more vulnerable and less resilient than the commercial banking industry, even with all of its problems.  And yet, like moths attracted to the flame, some policymakers and would-be policymakers ask us to send more of the nation’s financial business into the shadows.