What Is Shadow Banking?

This is Breaking The Dollar, the podcast that dismantles some of the biggest misconceptions about money. Presented by Gainesville Coins.

Hello and welcome back to Breaking The Dollar. I'm your host Everett Millman. And today's episode is going to discuss a perhaps little known aspect of the banking system and that is the aptly named shadow banking sector.

So a brief definition of shadow banking is almost exactly what it sounds like. It is banking off the books. It's loans made by non-bank institutions.

And that may sound odd. You may not know that those kinds of institutions exist, but yes, there are lenders out there who are not accredited banks. They are not held to the same regulations that the actual banking system is held to.

Anyone with a memory of the financial crisis should be concerned because even those regulations were not always enough to rein the banks in.

As I like to do on the show pretty often, let me give you a comparison or an analogy to help you understand this.

Payday lending. Hopefully you've never had to get involved in it.

Many, many people have, but think of a payday lender. Payday lending is not regulated the same way that an actual bank is.

It is a short term financing option for someone who cannot get the money elsewhere.

And one of the few advantages that they do offer is a payday lender does not report to a credit rating agency so it will not hurt your credit even though you have to take out this short term loan.

Now to compensate them for that, payday lenders usually charge astronomically high interest rates and the loans are always very short term, like a couple of weeks.

That's not a lot of time to pay back and you're paying a hefty cost for the price of having that money today.

Now that is a good rough approximation of what non bank lending is in general.

But the reason I brought up payday lenders is not just because that's something you may be more familiar with. It's also because there is a market to serve there. There are underbanked people who could not get a loan any other way than going to a payday lender.

And the same is true for shadow banking, for these non traditional non bank lenders.

There are corporations who cannot get financing through the bond market. Their corporate bonds are not going to be desirable. No one's going to buy them.

So the alternative is shadow banking.

And I'm not going to name names or pointing out any specifics. There are many companies who do this and there's even a pretty good chance that if you've gotten a mortgage in the past 10 years you may not have even realized that it was through a non bank lender like this.

So let's discuss a brief history of where this came from.

The real beginnings of shadow banking, at least in our society is in the 1980s with the expansion of the junk bond market and sort of as I mentioned before, it deals with companies who are not as credit worthy, who still need financing and they can't go through the traditional channels like selling bonds because nobody wants them and no one would trust them.

So that's basically the same idea as shadow banking. That does provide a necessary service. Even if a company is not well known or just getting off the ground or has a spotty credit history, they still need financing.

Now you could debate as to whether or not they deserve to have that financing or whether it's too risky to give it to them, but nonetheless, this is how they do it, and that is really where junk bonds were born.

As you get into the 1990s and the beginning of the last decade, this sort of financing expands to other types of loans.

So now we're not just talking about corporate loans, we're talking about subprime mortgages and subprime auto loans.

Really, it just starts kind of piling up.

Now, nothing really big changes in, in the shadow banking market until the collapse that happened during the financial crisis.

If anyone remembers the laws that were passed in the wake of that collapse, the big one were the Dodd frank regulations.

And what Dodd-Frank was supposed to do is put restrictions on banks so that we didn't find ourselves in this same scenario where we didn't have all these risky loans made that would destroy everyone's pensions. They tried to put in rules to prevent that and avoid it.

Now this is where you get into things like good intentions gone wrong and the law of unintended consequences because what Dodd Frank actually did with respect to shadow lending is it pushed a lot of this risky lending off of the bank's books and onto these existing shadow lenders.

So it's not that the problem cease to exist, it's simply that it migrated to a another sector of the economy.

And you do see that in fact in the years directly following the financial crisis, so 2009 2010 11 et cetera, shadow banking exploded.

And that's why I did say you may not even realize that your mortgage or your auto loan came from a quote unquote shadow lender. You may have assumed it was just the same as going to your local branch of your bank when in fact it is this non bank lender.

And let me pause for a second just to explain what I mean by that because there is an important distinction. You know what a bank is that they take in deposits. So you can save your money in a bank and then what the bank in turn does is it makes loans from those deposits.

That is not what a shadow lender does. They don't have any deposits.

They start with a certain amount of capital and they make loans and as we will find out a little later in this discussion, a lot of times their own financing is coming from traditional banks anyway.

So now they're just a middleman.

But back to Dodd-Frank. The way they tried to handle this problem is they increased the capital requirements for big banks to make loans.

And all that means is they have to have more money on reserve. They have to have more deposits and money on hand in order to loan out x amount of dollars.

And the regulations were especially stringent for riskier loans.

So the higher risk the loan, the higher the capital requirement, the more money the bank had to have in order to make that loan, which obviously increases the cost to the bank to write that loan.

This is where shadow banks get around the law and it's why all of this risky lending has moved to a new arena is because shadow banks, they are not banks, they don't take in deposits.

So in some sense they aren't risking other people's money. That's a definitely a major theme of banking and Wall Street is that much of what they do is with other people's money. That sort of changes the calculus of when you're taking a risk.

So shadow lenders, they get their financing and capital either from whoever the owner or founder is or more frequently they're getting short term financing from the big banks themselves.

And that's a very kind of strange arrangement where like I said, we haven't eliminated the problem of risky lending.

All it's done is sort of shifted locations and you have a new middleman playing that role, but indirectly the banks are still exposed because they are making the loans.

To the shadow lenders. I mean really, if you want to get down to it, shadow banking is like a more civilized version of a loan shark.

They're for people who can't get a normal loan, and so there's no oversight, no regulation really. And they can charge almost whatever they want.

Unlike a regular lender, they don't have to report and be transparent about their internal financials.

With a normal bank that's a publicly traded every quarter, they have to release a lot of their internal financial data so that potential shareholders can make an informed decision.

And the problem with that is that if there are a lot of loans defaulting, there's a lot of loans going bad, you're at least going to get a warning. With a traditional bank, you're gonna be able to look at their and see, oh wow, you know, they had 90% of loans performing well, now they only have 70% that should be a red flag.

Shadow lenders are not held to those same requirements. They don't have to comply with the same amount of oversight.

That's a problem and it's really an unavoidable problem right now because I want to reiterate the point that there is this explosion of shadow banking and it is really an unintended consequence of trying to clean up the traditional banks.

A lot of mid sized companies were priced out of getting a loan from a real bank. Once these regulations hit and you did see a lot of complaints about this, rather than simply having every small to mid size company go out of business, they had this alternative form of financing to go to with the shadow lenders.

So in some sense it's not entirely fraudulent or corrupt. It really is a natural consequence of the law and the rules surrounding banking.

Now one of the problems, another unintended consequences that shadow lenders necessarily have to lend money and are mainly going to be lending money to people with lower and lower quality credit ratings or companies with lower and lower quality credit ratings. Both cases.

That's sort of a snowball effect where now there's going to be many risky loans on their books and because the big banks are still indirectly tied to it, there's no safeguards. There's no sort of safety net or fail safe to protect everyone in the event of a wave of defaults.

And that's probably the main point about why you should be concerned about this.

Even if you yourself have good credit and you think it doesn't affect you.

Well these problems have a tendency to trickle down to everyone.

When banks are involved and corporate financing is involved, it is going to affect everyone's life if these things go south.

I mean, as a society, yes, banks and corporations make up a big, big part of our economy. So you can only do so much to limit your own exposure to these things.

It doesn't matter if your own pocket book isn't hit by a bank failure, if it means that the grocery store around the corner is going to close its doors because they can't get lending.

So we really should appreciate that the ramifications of these problems are widespread. They affect everyone.

As of now, the shadow banking industry as a whole is over $50 trillion worldwide and a lot of that is also in China, the second largest economy in the world.

So it's not just isolated to one sector. It's not just isolated to one country. This is a growing global problem.

So now is a good opportunity to check our mail bag of questions from listeners.

And this week's question from Keith in Savannah, Georgia and Keith asks, do banks hold gold? That is an interesting question because I'm assuming that a lot of people think every bank has like a vault where they keep a bunch of gold stacked up somewhere.

Not only is that not true, it's not a requirement. We no longer have a gold standard. And I'll just give you a quick history lesson.

Back in the 18 hundreds and even in into the early 19 hundreds except for war time, we had a gold standard where a bank had to keep a certain amount of gold, usually about 40% of their total deposits. They had to keep that amount of gold on reserve just in case people came and wanted to redeem their money for gold because that's what a gold standard is, it means that yes, you can issue paper money and you know credit, but that at some point you have to honor that piece of paper and give someone the real thing back in return, which is gold.

Now, that doesn't mean that since we've gone off the gold standard that no banks hold gold as reserves.

In fact, plenty of big banks do this. There's an area in the inner city of London where there are tons and tons of gold faults.

So yes, many of the big banks, they hold some gold, but especially central banks, which are government banks, almost every single one of them holds a significant amount of gold.

But that doesn't mean that your local branch has anything like gold in its vault. It might, but the chances are very good that they don't.

But that's a great question because I think it definitely busts the myth that gold actually is in those bank vaults and in most cases its not so good question. Keep them coming.

That does it for today's episode. Thank you as always for listening and be sure to tune in next time where we're going to get a little bit into the Federal Reserve and the creation of the Fed.

Today's episode was presented by our sponsors, Gainesville coins. You can find out more at GainesvilleCoins.com

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