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As banks retreat in the wake of the financial crisis, shadow banks are taking
on a growing share of their business, says Edward McBride. Will that make
finance safer?
May 10th 2014
IT WOULD BE hard to find a company with a greater sense of tradition than Hall
& Woodhouse brewery. Founded in 1777 in the English county of Dorset, it is
still based just a few sheep-speckled hilltops from the village where it began.
It is also still owned and run by descendants of its founder, Charles Hall (the
Woodhouses married into the family in 1847). It has been brewing on the same
site, using water from the same wells, since 1900.
The firm s grand Victorian brewery complex (pictured above), with its clock
tower, turrets and red-brick smokestack, has been preserved with pride. A
museum inside displays ancient brewing equipment, a stuffed badger and
sepia-toned pictures of the Halls and Woodhouses of yore, alongside records
from Hall & Woodhouse s earliest days. They show, for example, that on October
22nd 1779 the firm paid a Mr Snook 18 shillings for seven quarters (roughly
90kg) of barley. Even the names of the beers, such as Fursty Ferret and
Blandford Flyer (said to help ward off the insects that plague local
fly-fishermen) are steeped in rural nostalgia.
Until this year the firm s financial arrangements were equally traditional. It
never listed its shares or issued a bond. Instead, whenever it needed to
finance a big new project, such as the gleaming new brewing facilities that
abut the Victorian ones (now converted to offices), it borrowed money from a
bank. Given its steady income, its low level of debt and its pristine credit
record, it never had any trouble getting a loan, says Martin Scott, the firm s
finance director.
Hall & Woodhouse needed more reliable long-term creditors, so it reduced its
bank borrowing and turned to a shadow bank
The financial crisis changed all that. When in 2010 Hall & Woodhouse asked its
main bank, the Royal Bank of Scotland (RBS), to renew its regular 50m ($84m)
line of credit, it got a nasty surprise. The management of RBS had been far
less prudent than that of Hall & Woodhouse, borrowing heavily over the
preceding years to expand its business at breakneck speed. When its own credit
dried up, it was forced to turn to British taxpayers for a 45 billion bail-out
and began a frantic retrenchment, shedding 1 trillion in assets and cutting
its staff by 40,000. The bank told Hall & Woodhouse that it would renew its
line of credit for only three years instead of five, and at a sharply higher
rate of interest.
Mr Scott balked at this and arranged a similar loan facility at another, less
troubled bank, but the incident unsettled him and the owners. They decided they
needed more reliable long-term creditors, so they reduced their bank borrowing
and turned instead to a shadow bank a financial firm that is not regulated as a
bank but performs many of the same functions (see article). The one they picked
was M&G (the asset-management arm of Prudential, a big insurance firm), which
offered them 20m over ten years.
Shadow banking got itself a bad name during the financial crisis, chiefly in
the form of off-balance-sheet vehicles that were notionally separate from banks
but in practice dependent on them. Their assets were often securitised loans
that turned out to be much riskier and less valuable than expected.
These vehicles were meant to expand credit, and thus bolster the economy, while
spreading the risks involved; at least that was the justification for excluding
them from the banks liabilities and allowing them to hold relatively little
capital to protect against potential losses. Yet when they got into trouble,
the banks had to bail them out on such a scale that many of the banks
themselves then needed bailing out. The vehicles turned out to be an accounting
gimmick dressed up as a service to society.
Worse, they generally relied on short-term funding from money markets, another
form of shadow banking. Money-market funds, in which businesses, institutions
and individuals invest spare cash for short periods, involved a different sort
of subterfuge. Although all lending is inherently risky, they presented
themselves as risk-free. Their shares were supposed to retain a steady value of
$1, so when one of the biggest funds announced at the peak of the crisis that
it would have to break the buck , panic ensued.
The flight from the money markets added to the troubles of banks and other
financial institutions that relied on them for short-term borrowing. They had
made big losses, were struggling to borrow and so found themselves unable to
repay depositors, bondholders and other creditors. That left taxpayers on the
hook, both because governments in most rich countries guarantee small bank
deposits and because they were reluctant to let big banks fail, for fear that
the financial system might fall apart altogether.
Banks have since had their room for manoeuvre severely restricted to make them
safer. New accounting rules have made it much harder for them to park suspect
assets in off-balance-sheet vehicles. In effect, lending by banks must be
labelled as such. And they are now obliged to hold much more capital to help
absorb losses in case another crisis strikes.
There are only three ways for them to increase capital relative to their loans
and other assets: by raising more of it, by cutting costs or by trimming
lending and investment. Banks around the world have been doing all three for
several years, to the dismay of firms such as Hall & Woodhouse. They have an
especially strong incentive to curb long-term loans to business, since
regulators not only require them to hold more capital against them but also to
fund long-term loans in part with long-term borrowing, which is more expensive
than the fly-by-night sort.
As a result, bank lending to businesses in America is still 6% below its 2008
high. In the euro zone, where it peaked in 2009, it has declined by 11%. In
Britain it has plummeted by almost 30%. Bank lending to consumers has shrunk by
less, in part because most of it consists of mortgages, which take some time to
unwind (see chart 1). But all in all, big Western banks have shrunk their
balance-sheets by trillions of dollars.
This retreat of the banks has allowed the shadow banking system to fill the
ensuing void. Mr Scott of Hall & Woodhouse, for one, is happy to be able to
borrow from somewhere other than a bank. Although his arrangement with M&G is
slightly more expensive and less flexible than the shorter-term credit he is
still getting from the banks, he says it costs far less in terms of managers
time and allows the firm to plan for the longer term. British banks, he says,
simply do not offer ten-year loans to firms like his any more because they
cannot make a profit on them.
M&G has no such concerns because it is not considered a bank, nor regulated as
such. The money it has doled out to Hall & Woodhouse comes directly from
institutional investors, including Prudential and various pension funds, which
have given M&G 500m to lend to mid-sized British businesses. All the proceeds
from the loans go to the investors, who must also bear any losses; M&G simply
administers the portfolio of loans on their behalf and charges them a fee.
Whereas a bank intermediates between savers and borrowers by entering into
separate transactions with each, with all the risk that entails, M&G is merely
a matchmaker, with no skin in the game .
For all their residual worries about shadow banking, regulators like this
arrangement, because in some ways it makes the financial system safer. If the
economy stumbles, causing corporate earnings to slide and thus increasing the
number of defaults on loans such as Hall & Woodhouse s, any losses will fall
squarely on the institutional investors who put up the money.
It is not just M&G that has benefited from the banks retrenchment. The
business of direct lending or private debt (by analogy with private equity)
is booming. Investment funds that make loans of this sort raised $97 billion
last year worldwide and hope to raise a further $105 billion this year,
according to Private Debt Investor, a magazine. Another similar but exclusively
American category, business development companies, grew tenfold between 2003
and 2013, according to the Securities and Exchange Commission. At the end of
last year they held assets mainly loans to businesses of roughly $63 billion.
Don t bank on it
And private debt is only one form of lending that takes place outside banks.
Bond markets by far the biggest source of non-bank financing continue to grow
even as bank lending shrinks. In 2007 the value of all outstanding corporate
bonds issued by American firms was just under 29% of GDP; by last year it had
risen to over 42%, according to McKinsey. In South Korea the figure rose even
more dramatically, from 23% of GDP to 48%. Globally, corporate bond-issuance
doubled between 2007 and 2012, to $1.7 trillion, as firms everywhere took
advantage of extraordinarily low interest rates.
Money markets in the rich world seized up during the crisis and have not yet
fully recovered, but in China and other emerging markets they are growing
rapidly. A money-market fund launched last June by Alibaba, a Chinese
e-commerce giant, attracted 500 billion yuan ($81 billion) in its first nine
months.
Peer-to-peer (P2P) lenders websites that match savers with borrowers are also
growing like topsy, albeit from a tiny base. The value of loans chaperoned by
Lending Club, the biggest such website, has doubled every year since its launch
in 2007 and now totals over $4 billion. New firms are springing up the world
over to cater to all manner of niches, from short-term loans for property
developers to advances against unpaid corporate invoices.
The Financial Stability Board (FSB), a global financial watchdog, reckons that
shadow lending in all its forms accounts for roughly a quarter of all financial
assets, compared with about half in the banking system. But it excludes
insurance and pension funds from its calculations; add those in, and shadow
banking is almost on a par with the better-lit sort.
According to the FSB, shadow lending has grown by leaps and bounds in recent
years. The watchdog estimates that such loans in the 20 big economies that it
tracks rose from $26 trillion in 2002 to $71 trillion in 2012 (see chart 1
above). The FSB s data show bank lending growing at much the same pace, but
that is partly because, in the teeth of the crisis, regulators forced
financiers trying to game the system to reclassify much shadow lending as bank
lending. The FSB s data confirm that the sorts of shadow lending that worry
regulators, particularly off-balance-sheet vehicles, have atrophied, whereas
the sorts that please them, including direct lending, have rocketed.
The process of shifting lending out of the banks and into other financial
institutions has long been underway in America, where bond and money markets
are well-developed; banks there now account for only a quarter of loans. But it
is also gathering pace in Europe, where banks have been especially hard hit by
the crisis, and in other parts of the world.
And lending is just one area in which banks find themselves on the back foot.
The same combination of stricter regulation and increased competition is
hurting banks in other areas that used to be seen as an integral part of their
business, such as payments, the mundane but important business of transferring
money from one account to another.
The most common and lucrative way for payments to be made in the rich world is
through credit or debit cards. Regulators in America and the European Union
have been putting limits on the fees banks can charge for such transactions. At
the same time all sorts of new payment technologies are springing up, from
virtual wallets that claim to make the physical sort redundant to Bitcoin, a
scandal-prone electronic currency that nonetheless has the potential to turn
the business of sending money upside down, cutting banks out of the process
altogether.
New ways to pay
The trading of bonds and other financial instruments the mainstay of investment
banking is another area where banks are pulling back in the face of new
technology, new rivals and new regulatory constraints. Rules that bar or deter
banks from trading on their own account, and make it more costly to do it for
others by increasing capital requirements, have already resulted in a big drop
in the volume of bonds held by investment banks. Other regulations now being
introduced are pushing the trading of derivatives onto public exchanges,
greatly reducing banks influence over the business and the profits they can
make from it. Regulators are also discouraging banks from dealing in physical
commodities in any form.
Other financial institutions are cheerfully abetting the regulators drive to
wrest a lot trading from banks. The banks big customers chiefly asset managers
of various kinds are trying to create systems to trade more among themselves,
cutting out the middlemen. The shift away from fast-talking salesmen towards
electronic trading is also bolstering exchanges, technology firms and data
providers at the banks expense.
Similarly, asset management (which this report will not cover in detail) has
been growing much faster outside the banking system than within it in recent
decades. The crisis accelerated the trend, as some banks sold their
asset-management arms to raise money. Regulation designed to protect investors
from conflicts of interest makes it hard for a big bank to do business with an
in-house asset-manager, reducing the opportunities for savings or
cross-selling. And new technology is making it easier for firms and individuals
to find and invest in a range of financial instruments without the help of a
bank. The world s biggest asset manager, BlackRock, with about $4 trillion
under management, is now considerably larger than the biggest bank, the
Industrial and Commercial Bank of China, with assets of roughly $3 trillion.
Before the crisis the reverse was true.
This does not mean that banks are about to fade away; only that their relative
weight in the financial system is diminishing as other financial institutions
proliferate and grow. Indeed, that is largely what regulators intend. They want
to see banks shrink and welcome the transfer of risky assets to other parts of
the financial system. This special report will chart some of that transition
and consider the potential pitfalls.
Whatever the consequences, however, this new world is here to stay. As Mr Scott
of Hall & Woodhouse says of shadow lenders like M&G: The banks are going to
have all their best customers taken by these people.