What You Need to Know About the Shadow Banking System Now

The term “shadow banking” often elicits thoughts of shady back-alley dealings and loan sharks waiting to take drastic measures against debtors who can't pay. While that makes for an interesting story, it couldn’t be further from the truth.

Most consumers may not pay much attention to shadow banking because they don’t feel like it affects them personally. The problem is that the industry has grown so large that many people have loans originated through shadow banking, and they don’t even realize it.

Quicken Loans surpassed Wells Fargo recently to become the largest mortgage lender in the country, according to a 2018 press release (opens in new tab). Quicken has approximately 17,000 employees and closed nearly a half-trillion dollars of mortgage loans from 2013 through 2018 (opens in new tab). The most interesting fact of all? Quicken isn’t a bank. It’s a prime example of the vastness that shadow banking represents in the economy.

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What Is Shadow Banking?

Like many complex parts of our economy, shadow banking is often misunderstood. However, it is important to know what shadow banking really is, how it supports the economy and the risks it poses. According to the latest Financial Stability Board report, non-bank financing provides an alternative to traditional bank loans and is a major contributor to overall economic activity and growth. However, the benefit of that growth also comes with major risks to the economy.

When most people think of banks, they think of traditional commercial banks like Wells Fargo, Bank of America, Citibank and others. What makes these institutions true banks is the fact that they take deposits from savers and lend them out to borrowers in the form of mortgages, car loans and other debt. These traditional commercial banks are heavily regulated by federal and state authorities and must abide by Federal Reserve bank restrictions.

Shadow banking, on the other hand, refers to any type of lending provided by financial institutions that are not commercial banks and not regulated as banks. Like traditional banks, shadow banks rely on short-term funds to make longer-term loans. That’s where the similarities end. Since shadow banks are not depository institutions, they do not have deposits to lend out to borrowers. Instead, they rely on money from investors for making loans.

The difference? Unlike deposits that are FDIC insured, investor dollars collected through the shadow banking industry are not insured. It seems simple and straightforward, but that simple difference alone creates a major risk for investors and for the entire financial system.

Risk No. 1 – Investor Safety

Bank deposit accounts and money market accounts are insured by the FDIC and pose very little risk to account holders. Money market funds and other short-term, non-bank savings vehicles — the funding source for many shadow bank lending operations — are not insured. There’s really nothing wrong with providing investors with a decent short-term return in exchange for using their funds to make longer-term loans at higher rates, and conceptually, if investors understand these risks, then there should not be a problem. That’s how commercial banks have operated for centuries.

The difference lies in what happens when things go wrong. During the 2008 financial crisis, commercial banks were able to borrow money from the Federal Reserve to help weather the storm and provide account holders with access to their deposits. Shadow banking institutions cannot do that. They do not have access to short-term, government-backed funding and instead are forced to sell assets to raise cash and return money to investors. When asset prices are falling, as they were in 2008 and 2009, institutions are forced to sell assets at depressed prices just to be able to return money to investors, and it creates a downward spiral. This could make the next recession worse as dropping assets are sold at lower and lower prices to pay off investors.

That leads to much broader problems and bigger shocks to the overall economy and financial system.

Risk No. 2 – Liquidity

Just as an engine needs gasoline to run, the financial system needs access to short-term capital in order to operate. Banks and nearly every other monetary institution rely on access to short-term funds to meet liquidity needs and financial obligations. Real banks can access short-term funding in many ways that shadow banks cannot. When there is no short-term funding available, institutions that rely on it will suffer and possibly even fail in a short period of time. This is the reason the 2008 financial crises became so dangerous so quickly.

Since 2011, the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, has been monitoring the shadow banking system worldwide. Their latest report showed that shadow banking assets increased 7.6% to $45 trillion in 2016, growing faster than the rate of banks and insurance companies worldwide. To put things in perspective, shadow banking is now larger than the world economy in terms of total GDP, according to the report.

The good news is that shadow banking has been a major contributor to economic expansion since the 2008 financial crisis. The bad news is that there is always a balance between risk and reward. When the reward seems too great, the risk probably is too.

Risk No. 3 – Recession

It’s very difficult to predict a recession ahead of time, and the real causes often only become clear well after the fact. Looking back to the 2008 financial crisis, there were a lot of factors at play. Regardless of the specific cause or causes, there is no doubt that shadow banking played a major role in the severity of the crisis. A late 2018 Bloomberg article (opens in new tab) on shadow banking summarizes the role it played and points out that the most devastating liquidity problems were not due to a “run” on traditional banks as in the Great Depression. Rather, they were a result of problems caused by non-bank institutions like Lehman Brothers and Bear Stearns. With any portion of the economy being so dependent on an industry as large as shadow banking, there are bound to be risks involved.

The real question is whether post-2008 regulations and scrutiny of the shadow banking world will be enough to avert or minimize another similar crisis in the future.

In the meantime, it’s hard to decide whether to be thankful that we have shadow banking institutions to support the growth of the economy or to be fearful of what the future may hold as a result of that unchecked growth.

What Does All This Mean for Borrowers and Investors?

If you’re an investor who's in or near retirement, the main thing to take away from this is to make sure you don’t have more risk than you’re comfortable with at this age and stage of your life. If during the last crash you saw your 401(k) turn into a 201(k), now that we’re 11 years into this current bull market (the longest bull market in history) don’t let your guard down by having more risk than you’re comfortable with.

Don’t be lulled into a sense of complacency believing that stocks are “safe” just because they’ve been going up for almost 11 years straight. Remember that stocks are designed for potential growth and non-guaranteed dividends, they are not designed for safety of your principal. And don’t let the next recession, whenever it comes, catch you by surprise. Since World War II, the U.S. has had a recession on average every five years (opens in new tab), and it’s been 11 years since our last recession, so make sure you have a well-diversified portfolio that has the right amount of risk for you.

People often ask me how much in stocks they should have in their portfolio, and I always say that if you’re a retiree who doesn’t have a high appetite for risk then you shouldn’t have more than 45% of your retirement portfolio in stocks. The other 55% should be in safer assets, such as bonds, preferred stocks, CDs, structured notes and guaranteed, fixed annuities (NOT variable annuities) from A+ rated household-name insurance companies. A truly diversified portfolio is one of the most important rules of retirement.

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