New Alarm On Shadow Loans

Includes: IYF, KBE
by: John M. Mason

The Federal Reserve Bank of New York has just released a report on shadow banking. The report is called "Shadow Bank Monitoring." This report is cited in the Wall Street Journal article titled "Shadow Loans Sound New Alarm."

The basic theme of this report, shadow banking is a big part of the United States economy and will probably pay an even bigger role in the future.

Ianthe Jeanne Dugan writes in the Wall Street Journal article "Regulators estimate that shadow bankers control about $15 trillion, down from about $22 trillion before the crisis."

Federal Reserve statistics indicate that the commercial banking system in the United States has assets of a little less than $14 trillion.

Ms. Dugan writes that

"Among the hottest areas are loans made by groups of lenders to companies that have low credit ratings….

These leveraged loans soared to about $680 billion in 2007, then began falling out of favor. Now they are red-hot, with some $1 trillion expected to be plowed into the financing this year."

The alarm is within the regulatory community, not in the investment community.

Federal Reserve officials are very scared. Anything in the "shadows" makes them very nervous. For one, the Fed officials don't really know what is going on. They aren't inside. They don't get to scrutinize the books. And they don't have any idea about credit standards and loan underwriting.

Second, these organizations don't have traditional "deposits" and so the liabilities of these "shadow" institutions are not insured.

Third, these institutions are unable to borrow from the central bank and so do not have access to "liquidity" which creates a situation, according to the Federal Reserve report "The lack of such access to sources of government liquidity and credit backstops makes shadow banks inherently fragile."

I have talked with several Federal Reserve officials over the past year and they are very consistent in their response to questions concerning shadow banks. They get nervous, they don't want to give answers, and they don't like them…the shadow banks, that is. The basic conclusion I draw from these interchanges is that Federal Reserve officials don't really know what is going on and this makes them very nervous. They don't like shadow banks!

The thing is that given the costs of the regulatory system and the attitudes of legislators and bank regulators, the bankers, among other lenders, are cutting back on these borrowers and pushing more and more of them into the shadow banks. The report of the New York Fed continues "The deterioration in loan underwriting has come hand-in-hand with an increased presence of retail investors in the leveraged loan market…as relatively sophisticated investors…are exiting the asset class."

Anything the Fed doesn't like…it seems to denigrate.

And, the trend is going to continue.

This is why the Federal Reserve is so concerned about the ability to monitor these financial institutions. And, if the shadow banking sector returns to $22 trillion in asset size and the commercial banking sector stays about the same size or gets a little larger, the commercial banking sector becomes less than 40 percent of the assets of all "banks."

So the Federal Reserve puts out reasons for why we should care about shadow banking. The obvious reason is that "regulatory arbitrage" is taking place and that is exacerbating the issue. Then there are "neglected risks." For instance, the Fed report contends that shadow banks "accumulate assets that are particularly sensitive to tail risk." Okay.

Then shadow banks are subject to "funding fragilities." They are subject to downside risks that occur when the market is collapsing. They are subject to "leverage cycles". That is, as more and more credit is offered to the market, shadow banks are going to leverage more…they become more risky. And, there are "agency problems." As "banking" practices are divided up between more and more organizations there will be problems of transferring information from one institution to another.

These reasons, the New York Fed tells us, are why we should care about shadow banking.

The report closes with a discussion of how the risks in the shadow banking system can be monitored.

The indication is that the regulators have a long way to go.

But, this will not stop them. Unfortunately for them, there is still a long way for them to go in terms of getting the non-shadow banking side of the financial markets regulated…as least to where the regulators believe that they have plugged all the holes in the system that existed before the last financial crisis five years ago.

I still believe that if you want to invest in financial institutions you need to learn more about organizations that inhabit the shadow and think about investing in these companies rather than try and pick up something from a shrinking industry. If you stay with investing in commercial banks, focus on those institutions that are doing a lot with information technology…and, not just superficially…and are discovering the areas in the economy that are experiencing something special. And, my guess is that you will not find many financial institutions that satisfy these criteria.

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.