Rafferty Capital Markets analyst Richard X. Bove believes that in an industry that he sees as besieged by courts, politicians, and regulators, shadow banking offers creative, innovative people a chance to leave all that behind and simply get on with the business of making money.

Shadow Banking Offers Hope for the Economy

Yesterday, the Federal Deposit Insurance Corporation released the financial results of the nation’s banks in 2013. The table below provides a simplified look at the balance sheet of these banks.

Shadow Banking

What is immediately apparent is that the banking industry has done precisely what the regulators told it to do. It has increased its capital and liquidity and reduced its intangible and other assets. Moreover, it has shifted its funding to deposits. The one category that has not developed as wished for is debt. Long-term debt is down, not up as demanded.

I believe that the regulators also wanted loans to decline because loans represent risk. They did decline. They did not decline because there was no demand. The Federal Reserve Flow of Funds data shows that from the 4th quarter of 2007 to the 4th quarter of 2013 corporate debt rose by $2.2 trillion. Banks simply did not get their share because, repeating, the government did not want them to lend. It explicitly set up policies that incented money into cash and Treasuries not lending.

Collateralized Loan Obligations (CLO)

Now the government is unhappy over what it has done. Again, this is not because it wanted the banks to make more loans; it is because other entities are making the required loans – entities beyond the reach of the regulators. They are using a technique which bundles loans and sells a covered security backed by these loans called a CLO.

The press is suggesting that this could be illegal activity and the SEC is about to crack down. However, it is not illegal to package and sell loans. I would not discount the fact that these government lawyers are likely to lose their jobs if they do not find someone else to sue. They have run out of old issues and now they must find something new.

Instead what should be noted is that this is an area of great opportunity. The government has set up banks so that they will bleed loans to non-bank financial companies who create CLOs among other products. There is a significant opportunity here.

Enter Mr. Cavanaugh: Shadow banking

No one would fail to agree to the statement that Michael Cavanaugh is one of the brightest bankers in the country and that he was one of two people who were likely to replace Jamie Dimon at JPMorgan Chase & Co. (NYSE:JPM) (JPM/$60.87/Hold). Yet this very intelligent guy walks out of arguably one of the very best positions in banking in America to go to a firm which is clearly a leader in the shadow banking market.

Conclusion

From my perspective this is yet another indication that shadow banking will offer multiple investment opportunities for entrepreneurial people who are sick of dealing with regulators. Shadow banking is not hampered by the requirements that U.S. banks must adhere to. It is too appealing for a man like Mr. Cavanaugh to stay at a regulated company that is constantly being attacked in the courts, the regulatory establishment, and the press when a significant opportunity exists to walk away from all of this and just try to make money.

Unregulated, unaudited, by the government, business development corporations offer hope that innovation will still occur in the U.S. financial sector. They offer hope to those who want to invest in their businesses and grow the economy.