Want To Invest In Financial Institutions? Look To The 'Shadows'

Includes: IYF, KBE
by: John M. Mason

Readers of my posts know that I am not the biggest fan of investing in the banking industry. My number one reason for this is that the advances in information technology are making most banking organizations "legacy" institutions. I am not convinced that traditional banking models are as economically viable now as they once were and for ordinary deposit and clearing business, non-profit credit unions will do just fine.

Myself, I don't use a commercial bank for most of what I do. And, among my friends, they don't use commercial banks either. We can get all the "financial services" we need to live a good life without working within the confines of a traditional commercial bank.

The other thing leading to the demise of the traditional banking industry is regulation. The cost of regulation, especially to the small- to medium-sized banks is enormous. The cost of regulation to the largest banks is an irritation, at best, and a cause of distraction that keeps executives from focusing on their real business, at its worst.

Furthermore, regulation in this modern world is always fighting the last war while the institutions the regulators regulate are always moving to the new way to do business…especially if the business is out there in the new world of finance that has just been allowed by the information technology available to those that find it profitable to use.

But, this takes the banks further and further away from traditional banking practices.

If you are interested in finance and financial institutions these days, my suggestion is to look into the "shadows". More and more information is coming to light about what is going on in terms of alternative financial operations.

I recently wrote about what is happening in the derivatives market, "More Derivatives Trading Now in the Shadows." But, look at what has been reported in the Financial Times just over the last week, some of them appearing on the front page.

For example, we read "Shadow Insurance Schemes Multiply to $360 Billion." The author of the article, Alistair Gray writes, "U.S. insurers have offloaded more than $360 billion of liabilities to subsidiaries in jurisdictions with weaker reserve rules, underlining how insurers have shifted a swath of their holdings into the shadows."

Then, two days later, we read "Peer-to-Peer Lenders Turn to Bundled Securitization Deals." Tracy Alloway writes, "Peer-to-peer lenders that seek to cut out traditional banks have turned to one of Wall Street's most controversial techniques-repackaging loans into bundled 'securitizations.'"

"P2P lenders say they are able to use technology to extend loans at cheaper rates for borrowers while generating higher returns for investors."

This move has brought in hedge funds and large asset managers. "For the first time ever institutional investors can build their own portfolios of consumer credit without having to go to the investment banks and having to buy some ABS, or CLO or other securitized product." Ain't technology wonderful!

In today's Financial Times we read "Hedge Funds Step in Shadows of Repo Market as Banks Pull Back." Tracy Alloway and Arash Massoudi write "Some of the best known hedge funds have stepped into the shoes of Wall Street banks and expanded into the $5 trillion repo market, where financial companies lend out their assets in exchange for short-term loans."

They go on saying "The rise of non-bank participants in this market comes as new rules make the decades-old business less attractive for banks." It is likely that banks may participate less and less in this arena because of regulators wanting these banks to hold more capital against all assets on their balance sheets. So, if profitable, the business will just move elsewhere.

Right before our eyes the structure of the financial system is changing. We have the Federal Reserve conducting "Grand Experiments" with monetary policy. Both the policymakers and financial market participants are treading where no man or woman has tread before.

The quantitative measures of monetary policy have become almost meaningless as the financial system has broadened and expanded. The narrow measure of the money stock, the M1 measure, had to be expanded into a new measure, the M2 measure, to incorporate time and savings deposits, what Milton Friedman called a "temporary abode of purchasing power." The M3 measure of the money stock was created to incorporate more and more "liquid assets," but was discontinued in the 1980s because economists believed it to be confusing. But, now with more and more assets becoming close substitutes to demand deposits, it is very difficult to glean anything from the money stock or credit creation information.

In today's world, with the information technology available, the credit multiplier in the economy can become enormous. And, the ability to control the amount of credit outstanding has become almost impossible. Measures of volatility attest to this lack of controllability.

Investment opportunities in financial institutions are there … they just are not to be found in the traditional banking institutions. And, they are not readily available to the "ordinary" investor or to investors that do not have a lot of money. Since these investments are, to me, such a vital part of the future, I will be writing more and more about them going forward.

To me, the future of banking is "in the shadows." Advancements in information technology are not going to slacken and regulation is going to continue to force traditional institutions into non-traditional methods of doing business. This will create opportunities for investing … one just has to be diligent in pursuing them.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.