Garnet Capital Advisors Blog

Shadow banks are unable to tap into the Federal Reserve like regulated banks can.
Photo Credit: Wally Gobetz via Flickr cc

Just because it acts like a bank doesn't mean it is one.

Such is the case with what's known in the financial industry as 'shadow banking', which is a term that is used to refer to non-regulated institutions that are involved in raising short-term funds in the money markets and using them to purchase assets with longer-term maturities.

The term was coined back in 2007 by money manager and economist, Paul McCulley, to refer to a large proportion of financial activity that bypassed regulated commercial banks and other financial institutions.

Essentially, shadow banks can be simply defined as financial intermediaries that conduct banking functions with no ability to borrow from the Federal Reserve, lower regulatory oversight and capital requirements and without guarantees from public sector credit.

Shadow banking has certainly had its fair share of wild success. Even though banks are known to provide savings and checking accounts and all sorts of loans to borrowers of varying types, they do not have a limitless money tree from which to pluck their capital. Even the biggest banks have their funding limits, and are subject to stringent regulations that affect their lending capacity.

And that's exactly where shadow banking comes into the picture.

Where banks are either unwilling or unable to offer certain services to borrowers and investors, shadow banks step in. These institutions have been performing credit intermediation outside of the conventional framework of regulated banks, and have essentially acted as a pipeline of capital to originate or purchase loans, then sell them to other investors via securitization or other funding vehicles.

Through these vehicles, an increasing number of borrowers are more easily able to gain access to credit, while the institutions providing it would profit from making these mounting number of loans. These lending firms, in turn, would sell the loans to other investors through fixed-income securities. Borrowers benefit from affordable credit, and lenders rake in some handsome profits.

It seems like a win-win. Or is it?

Let's not forget that shadow banks are not subject to the same regulatory scrutiny that traditional banks are. This could inevitably place borrowers at risk. The economic crisis that started back in 2007 was in part due to risky loans that borrowers inevitably couldn't pay back. As such, traditional banks were slapped with stringent regulations, including the likes of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Since shadow banks aren't subject to such strict regulations and disclosures, borrowers may be vulnerable to negative implications. While traditional banks have access to steadfast and stable short-term liquidity like the Federal Reserve, shadow banks don't. As such, these shadow banks are much more susceptible to a squeeze in credit and capital liquidation.

With the Fed recently announcing an increase in interest rates, herds of investors could very well start to vacate the bond market, thereby slashing the ability for shadow banks to continue to provide vast amounts of capital to borrowers, and to the US economy as a whole.

Shadow Banking and the Emerging Fintech Scene

Interestingly, shadow banking emerged as one of the foundations in the development of avant-garde financial services, including fintech loan originators. These innovative firms involve private lenders as a pool of investors that originate loans for borrowers. The structure of such institutions fits quite closely to what shadow banking is.

Fintech is as hot as ever these days, and continues to be with investments in the sector passing the $12 billion mark over the past year. These internet loan originators have incredibly high equity valuations, and their sole motivation is to book more loans and sell them to others.


JPMorgan recently teamed up with fintech firm OnDeck to offer more innovative products to clients and remain relevant in a modern banking industry.
Photo Credit: Michael Premo via Flickr cc

Lending Club, for instance, boasts a valuation of around $9 billion. The fintech sector of the financial industry is estimated to achieve as much as $500 billion per year in global crowdfunding initiatives by 2020.

Even though these fintech startups are raising billions of dollars in venture capital, they won't necessarily kill off traditional banks. Instead, they may transform them in a sense.

We've already seen big banks like JPMorgan partner up with fintech companies like OnDeck. Such collaborations will likely continue into 2016 and beyond in order for banks to continue to gain insight into the digitally technological innovations that fintech brings to the table. They'll also help these alternative lenders tailgate the stability and profitability of traditional big banks.

Rather than compete, such partnerships will allow both sides to grow and profit while meeting regulations and offering consumers sound banking products.

Will Shadow Banking Lose Steam in 2016?

There is a good chance that the level of success that shadow banks have experienced in the past will slow down this year. These institutions will also likely realize rising operating costs as bank regulators increasingly analyze and impose structure to the fintech sector.

If anything, the closer scrutiny upon shadow banks by regulators will at least help to increase the level of transparency for the very borrowers who are banking with them. A boost in regulation among shadow banks could lead to heightened compliance that may put a cap on their level of profitability.

As regulators continue to step into the financial sector, banks need to continue to boost their efforts to offer innovative products to their clients in order to overcome obstacles and be profitable. And Garnet Capital is there to help.

We are an experienced team of valuation experts that has partnered with various financial institutions across the country to optimize loan portfolios through sound sales and acquisitions of loans.

Find out how we can do the same for your entity and sign up for our newsletter today.