There’s a lot of talk these days about the growth of a shadow banking market. Shadow is right! The growth of the commercial lending market outside of the universe of insured depository institutions and life insurance companies is real and its growth is accelerating, yet it is not easy to discern its size, shape and taxonomy. The shadow banking market, which simply means the community of lenders outside of the bank and lifeco cadres, is a logical response to a worldwide tsunami of regulatory activity designed to constrain innumerable facets of financial institutions’ operations which often seems more about retribution than the safety, soundness or integrity of the financial markets life.
With apologies to the old radio show “The Shadow”: Who knows what evil lurks in an excessively complex and ill-thought though regulatory briar patch? The shadow banker knows!
Just look around to see what’s happened to the traditional lending community over the past few years. An impressionistic take:
• One bank deeply cuts the compensation of its entire commercial real estate lending group, and shockingly, the great bulk of the team leaves.
• Another, for reasons of its own, excised commercial real estate lending from the bank twice over the past five years.
• The GSEs will be lucky not to be restructured to look like the Post Office. Do you want to rely on the Post Office for 95% of the residential mortgage lending in the U.S.?
• Europe wants to pay banking employees for less than the world market pays for their talent (and then tax away the rest). Sacre bleu! Banks and bankers are fleeing Europe.
• Basel III thinks sovereign debt is just terrific, but will punish banks with extraordinarily high capital charges for holding commercial real estate debt in general, and particularly for structured products, construction and development loans, all critical parts of the commercial real estate market place.
• The Volcker Rule is driving banks out of the funds world even as we do not yet know how the Rule will actually work.
• Dodd Frank Risk Retention, and Rule 122a and the new AIMFD Rules in Euroland, all requiring some form of skin in the game, has or will badly damage the business model regarding capital formation through the sale of commercial mortgage-backed securities.
• The new hedging and derivatives rules simply made it harder for a bank to provide designed derivatives products to facilitate lending transactions.
• Commercial mortgage lending is apparently bad and has caused the collapse of hundreds of small banks. I previously discussed this issue in "Undue Commercial Real Estate Risks Are Bad: The Mathematical Proof of the Blindingly Obvious."
• The FASB and IASB are both proposing new accounting standards for banks that would bring forward loan loss changes on fully performing loans long before any evidence of deterioration of the credit occurred. This is both mechanically difficult and will substantially decrease the profitability of the loan book even though there is actually no evidence of problems with the loans. All it will do is increase the cost of credit.
• And on the ground, up and down the halls of our banks and life insurance companies, as these institutions try to respond to an intense culture of criticism and second guessing, “Yes” is often punished while “No” is celebrated.
All this pushes people and capital to leave the traditional regulated community for the more unregulated world of hedge funds, private equity and specialty finance companies.
And if all that regulatory and legislative hostility represents a push, there is a concomitant pull not to be overlooked. As we have long known, there is a wall of money seeking somewhere to go. In a zero bound interest environment, where many of the old verities about asset allocation and the like simply don’t make sense anymore, money is in desperate search of yield, and this money is the high octane fuel for the asylum seekers from the regulated banking world. While Volcker will prevent banks from investing in fund vehicles in any material way (and the logic behind this continues to escape me) it does permit banks to invest in operating companies such as finance companies. Fund investors from pension plans, endowments, wealthy individuals and corporations with billions sloshing around the balance sheet who had looked for a 12-15% return, have finally come to realize that 6-8% is the new black and that money can fund core commercial mortgage lending. So the push-me / pull me of increasing difficulties of operating in the highly regulated sector and the attraction of money flowing into the unregulated sector guarantees the turbo-charged growth of the shadow banking market.
Is it good that commercial mortgage finance is moving off the balance sheets of the banks and life companies? Not particularly, although it’s not horrible either. There is, however, a certain loss of efficiency as the source of commercial mortgage financing moves from a low cost of funds world of banks and lifecos to an inevitably somewhat higher cost of funds environment. This amounts to a sort of transactional friction, or tax, on the efficient operation of capital markets, as funds need to be disintermediated from the banks and life companies into and through the shadow market, before getting to the ultimate users of capital. Perhaps, from a public policy point of view, if commercial mortgage lending were considered uniquely risky, maybe this could be considered a better alignment of risk and reward by removing this business from the arena of the insured depository base, but there doesn’t seem to be a compelling reason to view commercial real estate lending as fundamentally different than other species of finance. Indeed, in some respects, it is the bread and butter of the U.S. banking system.
So, the shadow banking world is expanding, and it seems likely to continue to expand as more of Dodd-Frank rolls out and populist anger continues to be directed (and, in some cases, stoked) toward the banking sector while resources flow away. But will the diminished banking and lifeco segment and the growing shadow banking market have the capacity to provide all the capital needed by the commercial real estate industry?
And as we’ve often commented in this blog, the government seems to be somewhat insensate to the unforgiving law of unintended consequences. Now, it’s not that the government’s worse at sorting unintended consequences than other large institutions; it’s just that it has more power, and consequently, its mistakes are magnified and its errors more consequential. Here, in an effort to regulate capital formation, they have just pushed that business into a non-bank environment. So what governments do now is a really good question. If the developed world governments react with a visceral hostility to capital formation “escaping” the traditional regulated world and commence a game of Whack-a-Mole trying to punish what they view as risky lending wherever it goes, the game of demonizing the financial sector, reducing compensation to bankers and penalizing what is perceived of outsized risk may lead to governments finding reasons to impose bank-type regulation on the shadow banking market. One can already see the green shoots of this crop growing across Europe with the European parliament considering compensation caps on hedge funds and other non-depository taking institutions. How this is intellectually justified is entirely beyond me, but never underestimate the power of democratically elected, perpetual ruling elites to react with a thoughtless tropism when confronted with the opportunity to stoke and then indulge populist anger.
For now, the hope of the commercial real estate industry is that somewhere between the banks and the shadow banking market there just is enough credit and investment to keep our markets functioning and growing.
Anyone interested in the success of the economy as a whole has got to hope that too.