Shadow Banking Provides Hot Opportunities in the Financial Sector
 first published in The Street | Jun 21, 2016

What is shadow banking? Well it isn’t that shadowy, for starters. All shadow lending refers to is lending by non-depositary institutions.

And if investors are looking for opportunities in the financial institutions sector, this is surely it.

Depending on how it is exactly measured, the assets of non-bank intermediaries have increased by about 25% since 2010, according to the Financial Stability Board.

The shadow lending market certainly took off big time before the credit crisis, but that was largely public asset-backed lending funded via what became an uncontrolled securitization market.

This time round it is somewhat different. The securitization market has come back but largely only for the best-quality, coherent cohorts of assets.

There have, for example, only been two securitizations of non-agency mortgages this whole year.

The shadow banking market that has grown enormously since the credit crisis, by contrast, is much more fragmented. It consists of multiple types of entities and many often mid-sized entities providing lending in many formats.

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Some are independent mid-sized private commercial or asset-backed lenders or lessors; some are consumer lenders or even highly efficient pawn chains; some are business development companies; some are real estate investment trusts; some are specialist credit funds; etc. Some of these entities are listed, and some aren’t.

Typically, these entities are funded by a senior line from a bank with some of equity below as first loss protection. Sometimes there is a mezzanine debt or preferred stock tranche between the senior line.

But more interesting models have also been developing that combine fund management structures with lending structures.

A typical lender naturally makes a margin by taking a spread between its cost of funds and the interest‎ that it charges on its loans.

But many of these shadow lenders are structuring themselves as funds and charging some kind of fund fee but then using the funds to earn a yield by lending or investing in credit products.

And why has there been such a boom in this part of finance? Well, in the end it is the old prohibition age story.

The depositaries have been so heavily regulated and constrained since the credit crisis that they are just not meeting the credit demand in the country. Many reasonably creditworthy individuals haven’t been able to get mortgages, depositaries have simply not been allowed to do certain types of lending and many are forced to hold very high liquidity ratios.

In fact, many depositaries that try to go into slightly higher-yielding lending to increase their returns have then been slapped with a new capital charge by regulators. So as said depositaries try to increase their return, they also have commensurately to increase their equity.

This doesn’t, therefore, really move the needle for the relevant bank’s return on equity, and so the whole point of trying to enter a new lending market is lost. Meanwhile, the depositaries are bogged down in endless compliance costs and time, with 12% of the operating cost of the banking system now estimated to be related to compliance.

But economics, like nature, abhors a vacuum, so as these depositary institutions no longer do their jobs, it is being done by the shadow lending sector, instead. The lending has simply shifted its locus and the regulator is, as usual, way behind the pace.
This isn’t to say that new regulation wasn’t needed after the credit crisis, but the Dodd-Frank Act now seems clumsy and ill-thought-out, with the growth of shadow lending just one manifestation of its failure.

Dodd-Frank did create the Consumer Financial Protection Bureau (CFPB), a new entity for regulating consumer lending. But consumer lending is only a small part of the shadow banking sector, and the ambit of the CFPB is only being worked out even now.

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Already, the CFPB’s role has been questioned as unconstitutional in one Appeal Court ruling. And until another total overhaul of depositary legislation occurs, which could take many years, the shadow lending sector will continue its ascendency.

Still, the real trick in investing in this sector is finding those shadow lenders that also combine into their business model modern finance technology in a powerful and genuinely value-added way. We might call it the shadow financial technology sector, and that is where there the real growth is.

But the lenders who just jumped on the recent bandwagon of hyped social-media valuations to try to flog loans online aren’t really finance companies at all but just plays on social-media mania. Surprise, surprise most of them have already come crashing to the ground.

No, the smart shadow lenders use technology in much deeper ways.

Sometimes it is indeed for marketing on the Internet. But more importantly it is often to develop highly automated and efficient underwriting algorithms or to automate much of the credit back-office process.

All of this allows underwriting to be both more scientific- and data-driven and then to allow for loan execution to be quick and efficient. Human oversight is always needed, but those shadow lenders who combine smart tech people with solid traditional finance/credit people are emerging as the winners.

The high-quality, FinTech-oriented shadow credit market is part of the key to our new financial infrastructure. Investors who like the financial institutions sector should study the industry and carefully get hunting.