Shadow banks’ growing loan portfolios may be a growing risk to the financial system

Article by Jenna McNamee  | May 9, 2023
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Shadow banks’ growing loan portfolios may be a growing risk to the financial system
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Banking
United States

The news: As the US banking system bucks, nonbank financial institutions (NBFIs), or shadow banks, are taking the reins. They tout easy and creative credit solutions but invite unknown risks to the financial system, per The New York Times.

Seizing an opportunity: The recent turmoil threatens a crisis of confidence at US financial institutions.

  • Reportedly healthy regional banks like PacWest and Western Alliance are dealing with volatile stock prices despite stable deposit levels.
  • Large US banks, despite benefiting greatly from an influx of deposits, are struggling with underwater bond portfolios that were established when interest rates were at rock bottom.

These banks’ woes are creating an opening for NBFIs—like money market funds and asset managers—to offer loans to customers looking for alternative lenders.

Shadow banks have gained traction over the past decade. Since 2013, they’ve grown the private credit space sixfold to $850 billion, according to Prequin. And since 2000, the returns on private credit have outpaced returns in the public market by 300 basis points, according to Hamilton Lane.

Credit destination: NBFIs say they’re safer because they don’t take on deposits and therefore aren’t subject to bank runs. They’re also willing to offer fast credit to typically overlooked consumers.

  • They are increasingly funding leveraged buyouts and relief financing, like Atlas SP Partners’ $1.4 billion financing to PacWest.
  • Shadow banks are also a destination for small and midsize enterprises (SMEs) that can’t get financing at traditional banks because it's tough for banks to determine their creditworthiness.
  • Shadow banks can offer SMEs more creative credit solutions or flexible collateral agreements. Though it may be more costly, SMEs can form more trusting partnerships with NBFIs than traditional banks.

Risks and warnings: But shadow banks’ speed and flexibility come at a cost.

Their loans typically come with higher rates and tougher terms than traditional banks. They also operate in a dramatically less regulated space than banks, incentivizing them to take bigger risks, like high leverage and major asset/liability mismatches, to maximize returns.

  • JPMorgan head Jamie Dimon warned that shadow banks don’t help clients during tough times, and that businesses that work with shadow banks could face foreclosures faster.
  • Last month, the International Monetary Fund (IMF) warned that shadow banks could cause the next financial crisis.
  • US regulators are pushing for legislation that would make it easier to designate NBFIs as systemically important, which would put them under Federal Reserve supervision.

The big takeaway: While shadow banks may be an attractive alternative for some consumers, the full extent of risks in shadow banking is still unknown. And with many predicting that the US is careening toward a recession, now is probably not the best time to find out.

This article originally appeared in Insider Intelligence’s Banking Innovation Briefing—a daily recap of top stories reshaping the banking industry. Subscribe to have more hard-hitting takeaways delivered to your inbox daily.