Are Regulators Helping To Create The Shadow Banking Business?

by: John M. Mason

Almost everywhere you look, some extension of financial innovation is popping up, either with a new, fresh idea, like creating bonds that are paid off by rental residential properties, or resurrecting an idea that lost favor in the financial collapse of recent years, like commercial mortgage-backed securities (CMBS).

Tracy Alloway writes about the resurgence of the CMBS in an interesting piece, "Competition for Banking Business Lurks in the Shadows."

Alloway discusses what she observed at a conference of people interested in commercial real estate that was populated by "Wall Street bankers who originate commercial real estate loans and then bundle them into bonds.

What's new? Well, the conference has stepped up the venue and is drawing individuals that never came to these "gigs" before.

"The sprawling new location is symbolic of the broader recovery in some parts of the securitization market. Sales of CMBS totaled $102 billion last year, the highest since the financial crisis, and issuance is expected to increase further in 2014."

But, the real news she argues is that "this year's Miami gathering played host to an expanded selection of non-bank lenders."

OMG…these guys are slipping in all over the place!

And "just like the banks, shadow lenders serve a purpose-they create credit and securities that are demanded by investors…."

This is the future and the future is being helped along by Dodd-Frank and the bank regulation industry.

Alloway is very clear on this point as she writes "The growth of shadow lenders is therefore demonstrative of a truism of finance: squeeze one segment of the system and the activity you are attempting to control is likely to manifest itself elsewhere."

As banks retreat from serving the needs of the marketplace, others pop up and provide similar resources in a "cheaper and more efficient way."

In other words, if the market demands some kind of financial support and it is cost effective for someone else to supply that support…it will get done.

Remember, money is only information…and information is only 0s and 1s.

It can be relatively inexpensive to get into the business these days…and more and more people seem to be doing it. And, the new entrants have a big cost advantage over existing banks and financial institutions. Furthermore, these new entrants tend to be more technologically based and don't need extensive branching systems to do what they intend to do.

I am meeting more and more of these people every month…and I find most of them impressive to say the least.

It is also telling to me that there is a real fear of these alternative financial institutions in and among both the traditional financial institutions and many regulators. These people respond to a favorable view of what is going on with ominous warnings about all the opaque things these alternative financial institutions do and the desire of these organizations to avoid regulations. Alloway alludes to the talk that "Shadow banks are unregulated institutions that lurk in the dark corners of the financial system." The word "lurk", I believe captures the tone of their criticism.

My belief is that the direction that these alternative financial institutions are taking us is the direction the system would be headed in anyway. The evolution of information technology is the driving force.

But, regulation is having a major impact on exactly how the whole financial industry is evolving. I believe that Alloway's quote presented above captures this thought. Squeeze the system one way and the activity you are attempting to control manifests itself elsewhere.

In addition, however, there are unintended consequences that can accelerate what is happening or cause substantial harm that will result in a new structure to the financial system.

Alloway writes "While it's fair to worry about the rise of shadow lenders themselves, it seems there is perhaps also an under-appreciated danger: the possibility that non-bank lenders will encourage riskier behavior at larger banks that now find themselves compelled to try to compete with the shadows….Already there is talk of slippage in underwriting standards across the board and the return of certain worrying per-crisis lending practices as competition heats up."

Commercial banks just don't have the expense structure to compete with the new non-bank lenders. And, the higher rates that some of these non-bank lenders receive allow them to absorb a larger loan loss experience…although that is not happening yet. I should add here that the organizations I am talking about here are not payday lenders and they conform to legal restrictions connected with usury laws and so forth.

The construction of the United States financial system is changing. There will be large banks. The largest twenty-five commercial banks in the United States control about two-thirds of the banking assets in the country. Add in the foreign-related institutions to this total and you get over seventy percent of the banking assets of the country. The other twenty-eight percent of the banks are controlled by a little more that 5,900 commercial banks. Right now this number is shrinking by about 200 institutions a year…encouraged by our regulators.

The credit union system is going to grow and take over a lot of retail banking business. They are mutual institutions that are not profit orientated and have a much lower cost structure than do most of the community banks. I see this sector growing in the future.

Then you have the non-bank, alternative finance institutions. This sector is growing and is somewhere around the size of the commercial banking system, give or take a trillion dollars one way or the other. Right now, this is a place where investment opportunities exist.

I have been writing this story for quite a few years now and I still believe it to be true. To put my money where my writing is, at the end of last year I formed a new company, New Finance, LLC, to work in this space. I find it to be an exciting place to be…a place with finance intersects with some of the latest information technology.

Tracy Alloway, at the Financial Times is one person who is observing this trend, but there are many others. Their reporting, at least on the surface, does not necessarily seem that exciting. But, they tell a story of developing institutions and markets that are going to play a big role in the near future. I heartily recommend that you take a closer look at all that is happening in this area. As you do, I think you will find some good opportunities to invest. I will do my best to bring some of these opportunities to your attention.

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.