In the past few months, it appears, shadow banks, financial firms that make loans but aren’t actual banks, seem to be making a come back. In case you have forgotten about these things already, shadow banks are financial firms, like hedge funds or money market funds or even insurance companies, that aren’t real banks – no deposits, no branches, no ATMs – but make loans nonetheless. And, oh yeah, they might have caused the financial crisis.
Paul Krugman said, shortly after the financial crisis was over, that one of the main things financial reform must do was to bring “non-bank banking out of the shadows.” But Dodd-Frank, according to some recent reports, is doing exactly the opposite. Here’s why:
Earlier this month, the NYT’s Dealbook reported that a number of start-ups were turning to hedge funds to get loans after being rejected by their bank. The company in the article Rentech, which is in the clean energy business, got $100 million loan from a hedge fund. The NYT says the business was moving to hedge funds because banks were worried about making risky loans. But an article in Financial Times today puts the revival of shawdow banking square at the feet of Dodd-Frank.
Many believe, along with Wes Edens, founder of Fortress Investment Group, that this is the golden age of non-bank financial companies; a lot of smaller companies and individuals need credit but rather than do it through banks hamstrung by regulation, they can provide it far more profitably and flexibly through non-banks.
The emphasis is mine. The question is how much of a bad thing is this. And I am not so sure it’s bad at all. First of all, any credit at this point in the recovery is a good thing. Start-ups like Rentech create the bulk of the economy’s jobs. So we need a system that gets them capital to expand. And that means we need a financial system that takes risks and makes these kinds of loans. The question is do we need the institutions that are making these loans to be backed by the government. And I think the answer is probably no. The problem we had in the financial crisis was not that unregulated non-bank lenders pulled out of the market. It was that all banks pulled out of the market, because they were making risky loans, or relied in some way on this shadow banking system to be able to continue to make loans. The problem wasn’t that there were shadow banks, but that the shadow banks had become part of the regularly banking system.
So if Dodd-Frank pushes some of these loans out of regulated banks, while at the same time upping capital requirements to make sure banks are less reliant on shadow bank financing themselves I think that is a good thing. You still have the problem of liquidity drying up during a financial crisis, because it is harder for the Fed to pump cash into the non-banking world. But I don’t think there is anyway to solve that problem. In recessions, and financial crises in particular, you will have less lending. There is no way to stop that. And yes, there will be some start-ups that won’t get money and jobs that are lost. But if you can make sure it is just the shadow banks that have to go into hiding and not banks in general then I think you can have a much more mild crisis and recession than the one we just had, which nearly took down not just the financial system the one that many of us didn’t know we relying on, but also the one right in front of our eyes. That’s what really hurts confidence, and economies.