Goldman Sachs On The Rise And Danger Of Shadow Banking

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Goldman Sachs Equity Research published a report titled The Future of Finance: The Rise of the New Shadow Bank on Tuesday, March 3rd. GS analysts Ryan Nash, Eric Beardsley and colleagues focus on the ongoing changes in the banking industry, highlighting both regulatory changes and the development of new businesses  and new business models.

In the overview to their report Nash and Beardsley note: “From Lending Club to Quicken Loans, Kabbage to CommonBond, new faces and new names are impacting the way we bank and borrow. The twin forces of regulation and technology are opening the door for an expanding class of competitors to capture profit pools long controlled by banks.”

Regulation and the emergence of shadow banks

The GS analysts point out that several new regulations have led to an evolving competitive landscape as stricter capital requirements means reduced credit availability in some sectors, scrutiny of high-risk lending has resulted in many banks reducing commercial activities such as loans to non-investment grade firms and new rules regarding the consumer market have led to higher credit costs, offering an opportunity for alternative lenders. These regulatory changes are a big part of why new shadow banks are being created, and why traditional borrowers like Blackstone and other asset managers/private equity firms are now becoming lenders.

Technology changing business models and disrupting financial industry

Nash and Beardsley also highlight that he combination of big data analytics and new distribution channels is permitting technology start-ups to introduce new business models that are disruptive to traditional banks, especially in the consumer lending sector. The new lending firms have the advantage of lower cost bases than most banks, meaning they can offer loans at lower interest rates.

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Although these new firms are still relatively small, the total market is quite large and the shadow banking market share is growing rapidly. Of note, new technology is also “growing the market” in some areas that were historically underserved by traditional banks.

Shadow banking likely to grow market share in areas representing $11 billion in profits to banking sector

Shadow Banking

The Future of Finance identifies six areas where shadow banking could eat into the profits of traditional banks. “We see the largest risk of disintermediation by non-traditional players in: 1) consumer lending, 2) small business lending, 3) leveraged lending (i.e., loans to non-investment grade businesses), 4) mortgage banking (both origination and servicing), 5) commercial real estate and 6) student lending. In all, banks earned ~$150bn in 2014, and we estimate $11bn+ (7%) of annual profit could be at risk from non-bank disintermediation over the next 5+ years.”

An overview of shadow banking in the U.S.

Shadow Banking

For the purposes of their report, the GS analysts define shadow banking as “activities – primarily lending – conducted by non-bank financial intermediaries that provide services similar to traditional banks.”

Shadow banks are typically not subject to the same regulatory oversight as traditional banks. Though large portions of the broader shadow banking sector (especially mortgage-related) have been winnowed out since the the Great Recession, several new types of shadow banking have emerged and some existing shadow lenders have seen major growth due to a slew of regulatory changes for banks. The GS analysts highlight two major regulatory reforms: the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 after the financial crisis, and the continually evolving bank capital standards (Basel III). These regulatory changes have lowered margins on some bank products, which obviously creates an opportunity for new entrants.

Shadow Banking

Of interest, the origins of the term shadow banking actually derive from the financial crisis. The term was coined in 2007 by former PIMCO chief economist Paul McCulley in reference to “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures” that led to the lending bubble from 2005 to 2007.

MCCulley pointed out that these highly levered investment vehicles were almost completely dependent on wholesale short-term funding and were not backed like banks’ FDIC insured deposits or “the backstop of the Fed’s discount window”, which meant they were vulnerable if/when the liquidity dried up in the bond market. Even though most of these leveraged financing vehicles were connected to or created by banks, the large majority of them saw no Fed regulation, which is why shadow banking has become a term typically used to criticize the systemic risks created by the activities of non-bank entities.

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