Shrinkage in lending – can shadow banking help?

A leading article in the Financial Times carried the title – Non-banks colonise former bank territory. This refers to the popularity of shadow banking, which is gaining strength at the time when high street banks are licking their wounds from paying heavy fines imposed by regulators for past irregularities.

At this stage it helps to define the concept of shadow banking. This is the provision of capital by loans or investments to companies by other companies that are not banks. The article in the FT mentions a number of examples as providers of credit, such as insurance companies, credit investment funds, hedge funds, private equity funds, and broker dealers.

So one may well ask what is new in this type of lending.

The major difference is that it is not as yet regulated as a banking function and because of its freedom of operation (and lower costs) some are branding it as a panacea at a time when banks are shrinking their balance sheets and ongoing intensive ECB mandated audits. For adherents of shadow banking they make a case for it to continue its operation unhindered by excessive regulation.

It is true that retail banks in Malta can be applauded for supporting industry sectors during the recession, but many are witnessing a change of heart and their rate of lending is slowing as is happening in some European countries. On the other hand banks in the US are better capitalized and much safer today than before the financial crisis, yet notwithstanding shadow banking offers an alternative source to a wide range of businesses and employees, and fills a real gap in the US market.

As the G-20’s Financial Stability Board noted in its policy framework last year shadow banking created “competition in financial markets that may lead to innovation, efficient credit allocation and cost reduction.”

Within Wall Street not many disagree that blaming bankers is quickly turning out to be a  favorite national sport yet conservative business leaders yearn for new regulation to muzzle the proliferation of shadow banking. Banks in Europe are lending less in order to comply with Basel III and other regulatory requirements issued this year by the European Central Bank since it took over as a central regulator last month.

In addition, European banks are pulling out of emerging or growth markets and trying to lick their wounds due to non-performing loans. At the same time even in Malta there is a pressing need for easy finance at more competitive rates especially to exporters.

The government in its budget proposals wishes to promote economic growth and create new jobs which in turn need to be financed so new businesses opportunities (especially the promotion of Public Private Partnerships) need financing. Banks may be licking their wounds after the results of tough ECB audits which put them under the lens, exposing any slow performing loans in their cupboards.

As a matter of priority these need to be refinanced. As banks cannot or will not provide the financing required to emerging industrial users the vacuum was filled by a proliferation of unsecured / unrated corporate bonds that are quickly snapped within 24 hours of issue. Last year one noticed a persistent dialogue between the Governor of the Central Bank and the banking community criticizing the low levels of lending and the relative high rate of interest on loans (particularly to SME’s).

The Central Bank governor reminds us that Malta has the fifth highest rate of bank lending interests after Cyprus, Greece, Portugal and Slovenia, while Labour MP Silvio Schembri, who chairs the economic and financial affairs committee, is also of the opinion that interest rates are too high for small and medium enterprises.

He promised to table in parliament a study of how SME’s are faring under current banking practices. It is no cliche to say that SMEs are fragile and in need of a level playing field when they access credit to expand operations.

All this is happening at a time of disinflation and a policy of negative interest on inter-bank deposits by the ECB. All the while local banks marginally pay 0.3% p.a (or nothing) on savings accounts to depositors and this gives a generous profit margin since the top rate charged to industry is higher than that recommended by the ECB.

Still one cannot ever understand the enigma how local banks manage to beat the crisis and consistently report a higher digit growth in pre-tax profits, more than that registered by the economy – although this year the two main banks reported a dip in after tax profits.

The Chamber of Commerce has echoed concerns over the declining levels of bank lending yet it stands convinced the decline in demand for commercial credit does not relate solely to exorbitant interest rates but is probably due to business uncertainty (quoting a drop in demand from manufacturing, import and distribution).

It points to problems on competitiveness and loss of markets due to high energy costs even after the proposed 25% electricity tariff cut expected next year and as a consequence  production is channelled to lower cost countries.

The Opposition were quick to lament how Eurostat reported a drop in exports. Again one can still hear the battle cry by Central Bank Governor who extols the perils of reduced volume of lending, saying if new credit is not stimulated, the economic forecasts for higher exports would not be reached.

With regard to lending volumes, compared to the rest of Europe, the governor says that we do not seem to follow the ECB trends. As can be expected the views of the ex-minister of finance come with a word of caution. Opposition finance spokesman Tonio Fenech said credit growth appeared to be weak and sowed doubt if the forecasts for the 2015 target performance in the budget document could be attained unless there is some improvement in exports.

He feared the rally in business is not export-driven but relies more on domestic trade. Acting as a doubting Thomas he remarked that this apparent shrinking in bank lending, coupled with weak retail volumes and weak credit growth, points to uncertainty in attaining the set targets in the Maastricht criteria and the excessive deficit mechanism triggered due to election slippages in 2012/13.

So what is the solution, given that in reality banks are becoming more risk averse? A partial answer can be found by reading an interesting study published in The Economist concerning shadow banking. This article examines the impressive growth of this sector. It was the crisis of 2007-09 that brought the uniqueness of shadow banking under the spotlight; or rather, made a process that had been accepted as a benign force of financial innovation and competition to be considered by some as constituting a political problem.

Five years ago Paul McCulley, then of PIMCO, argued that “the growth of the shadow banking system, which operated legally yet entirely outside the regulatory realm “drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crises we’ve ever seen”.

After McCulley first coined the term, it became clear that “shadow banking” was both a stroke of genius and an unfortunate choice of words. Unfortunate, because confusingly the term “shadow” banking resonates with “shady” or underground economic activity.

Taking a leaf from a recent Economist report one comes across the following extract “in most countries, only banks can hold deposits guaranteed by the state, and only banks have a standing offer of credit from the central bank. With these privileges come lots of rules and restrictions. That is because banks, although essential to the smooth operation of an economy, are vulnerable to runs, which in turn can cause contagion leading to recessions. Banks have since had their room for maneuver – particularly in lucrative investment divisions – severely restricted to make them safer.

“New accounting rules and Basel 111 have made it much harder for them to hide suspect assets in off-balance-sheet vehicles. In effect, lending by banks must be labelled as such...”.

All this does not mean that the uniqueness of this innovative vehicle will push traditional banks out of business; only that their relative weight in the financial system may start to diminish as other credit institutions proliferate and grow.

To conclude, the shadow banking system in other countries has so far escaped regulation primarily due to the fact it does not accept traditional bank deposits and this “light touch regulation” lowered costs, enabling it to give better lending terms to SMEs. It is true shadow banking may be too innovative to catch up in Malta but as an immediate solution there is a pressing need to introduce a development bank to facilitate more bank lending at competitive interest rates. Only thus can the seeds sown by the budget germinate and grow to bolster the economy and boost job creation.