Q: What do Merrill Lynch, GE Credit Corp., Visa Inc., Ford Motor Credit Company, and the American International Group (AIG) have in common?
A: They are considered to be part of the United States ‘shadow banking system’.
As either the sole or one of their primary business activities, these companies offer various types of credit-related products and services to both individual and corporate customers. The credit granted can be directly associated with the purchase of the company’s products (i.e. jet engines sold to an airline transportation company in the case of GE Credit, or an auto loan for the purchase of a new car by an individual in the case of Ford Motor Credit). Alternatively, it can be related to offering standard consumer retail credit in the case of Visa, or margin loans for their brokerage customers in the case of an investment bank/dealer such as Merrill Lynch.
Until the 1960s, commercial banks were the dominant supplier of credit to U.S. consumers and businesses. Commercial banks operated under regulation and supervision by the U.S. government banking regulators and the Federal Reserve. Accordingly, the majority of the credit created in the U.S. was easily monitored and controlled by changes in regulation and/or changes in capital or reserve requirements.
However, during the 1970s corporations in the United States began to compete effectively with the commercial banks in terms of loan origination through the establishment of company-specific financing subsidiaries. This disparate group of lenders was not subject to any of the regulation or controls applicable to the traditional banking industry – and hence the term ‘shadow banking system’ was applied.
The diagram below shows the growth of the U.S. banking systems liabilities as compared to the traditional banking system during the past 50 years. From a standing start in the early 1960s, it had grown by the 1990s to overtake the size of the liabilities in the traditional banking system. However, the real growth of the shadow banking system began in earnest and grew to a peak size of over US$21 trillion by 2008, which was also approximately 40% larger than the size of the traditional banking system at the time.
There are two primary factors that predicated the rapid growth of the shadow banking system in the United States: deregulation and asset securitization. The deregulation of the U.S. financial services industry further accelerated the expansion of these non-traditional lenders into all areas of loan origination by blurring the line of distinction between commercial banks and shadow banks. Secondly, the concurrent growth of the asset securitization market during the deregulation period permitted the shadow banks to obtain funds via the securitization of their various loans such as credit card receivables, automobile loans, as well as residential and commercial mortgages. Securitization involves the arms-length sale of financial assets by a company to a bankruptcy-remote entity commonly referred to as a special purpose vehicle (SPV) in return for cash. The shadow banks found many willing institutional investors to purchase their asset-backed securities (ABS), as institutional portfolio managers at mutual funds, pension plans and life insurance companies sought investment in ABS in order to both increase return and improve the overall diversification of their fixed income portfolios. Securitization allowed these non-bank entities to readily obtain financing directly from institutional investors rather than from the bond market or traditional bank corporate loans.
Despite its rapid growth and size, the shadow banking system did not receive much attention in the mainstream press until the 2008 financial crisis when a number of the larger shadow banks (and commercial banks) required significant amounts of government support and funding from the Federal Reserve and United States Treasury Department in order to prevent a further contagion in the U.S. and global financial markets. Discussion and analysis still exists around the role that the shadow banks played in the circumstances leading up to the financial crisis, as the Obama administration attempts to bring the shadow banking industry under some form of regulation in order to prevent this sector from contributing to a similar financial crisis in the future.
As indicated by the graph, the shadow banking system experienced an abrupt reversal in its long-term growth rate and experienced an unprecedented decline of approximately US$5 trillion since the time of the financial crisis. This rapid decline in size is due to a number of factors including the continued standstill in almost all types of ABS underwriting, the significant hardening in lending standards, and the unwillingness of business and individuals to borrow since the financial crisis. This shrinkage in the size and credit availability of the shadow banking system will further hinder the Federal Reserve’s current efforts to restructure the weakening U.S. economy, as it presently has no monetary policy or regulatory tools to encourage loan creation in the shadow banking sector.
Given the role that credit growth plays in U.S. economic growth, it is clear that the shadow banking sector will cast a very long shadow over its tepid economic recovery.