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Why So Much Affection for Shadow Banking?

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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.

I feel it important to mention that these proposals do not give much attention to customers.  They should.  Narrow banks also mean narrow services.  That means narrower customer choice.  Today, when a customer wants financial services of whatever nature he can pretty much go to a bank and the bank can figure out how to meet those needs.  In a narrow bank world, customers would be forced to wonder, "Just what can the bank do or not do for me and my family or my business?"  There will be nonbank competitors who will not labor under that same difficulty in their customer offerings, and I doubt that they will be quiet about it.

Congress considered, debated, and rejected the narrow bank schemes in the 1990s. Shrinking the banking system and expanding the shadow banking world did not look very attractive then.  I still do not see why inflating the shadow banking world makes for good national policy today. 

Wayne A. Abernathy is executive vice president for financial institutions policy and regulatory affairs at the American Bankers Association.  Previously he served as assistant secretary of the Treasury for financial institutions and as staff director of the Senate Banking Committee.

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Comments (3)
Thought provoking article. Completely agree that it is very puzzling to be enamored of shadow financial institutions, especially after their main role causing the 2008 financial crisis and its negative aftermath. Whilst they serve a purpose in an economy, they are regulated and supervised a lot less than banks. If a major purpose of Dodd-Frank is to minimize systemic risk, then better rules to regulate and supervise shadow financial institutions is critical. At the moment, all that is happening is risk transference from the banks into the shadows. Mayra Rodriguez Valladares
Posted by Mayra Rodriguez Valladares, MRV Associates | Thursday, January 31 2013 at 11:47AM ET
Let's be Frank and not Doddge the issue.... If your goal was to undermine the very fiber of the American Banking Industry, short of military force, could you devise a better plan than the current administration's course of action? It's outrageous!
Posted by Telyst | Thursday, January 31 2013 at 4:58PM ET
Some claims in the article seemed to be very sweeping, though acknowledge the benefits of shadow banking, principally the competition to conduct financial intermediation that has largely been enabled by information technologies. Additionally, shadow banking extends waaaay beyond a handful of large investment banks and insurers who bet big on mortgages and swap hedges.

Shadow banking thrives because it just doesn't cost much to move electronic currency securely, at least not as much as many 'traditional' commercial banks (i.e. BofA, JPMorgan,...) would like to charge.

^ is the answer to your opening statement. Intermediation costs less than traditional banks charge and shadow banks fill that Supply/Demand gap
Posted by slipleft | Tuesday, February 26 2013 at 9:14AM ET
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