Last year, several large banks—Silicon Valley Bank, Signature Bank, and First Republic—failed. Financial regulators interrupted the cascade by expanding deposit insurance and establishing a new emergency-loan program at the Federal Reserve. Now, less than a year removed from the 2023 crisis, another bank, New York Community Bank, appears to be tottering. While regulators’ need to scramble so soon after last year’s crisis illustrates banking’s inherent instability, financial intermediation outside the traditional system (“shadow banking”) could be a boon for financial stability.
Let’s take a step back. Fundamentally, banks take short-term financial contracts (deposits) that promise safety and transform them into long-term financial contracts (loans) that necessarily involve risk. This combination unavoidably exposes banks to the sort of runs memorialized in the classic 1946 film It’s a Wonderful Life.
As financial systems evolved, they developed a number of mechanisms to manage banks’ instability: Walter Bagehot’s lender-of-last-resort model; deposit insurance; the tangled mess of capital and liquidation regulation embodied in the international Basel III standards; and the government backstop implicitly enjoyed by so-called global systemically important banks. These mechanisms help mitigate the risks of banking, but they cannot eliminate them. They also create significant problems, such as reducing the financial system’s efficiency by favoring certain banks over others and imposing distributed costs through implicit subsidies.
Shadow banking, also known as nonbank financial intermediation, can be a market-based means to the desired end of stronger financial system stability. The practice is on the rise. Indeed, the Financial Stability Oversight Council’s latest annual report named addressing nonbank financial intermediation one of its top priorities.
The largest form of non-bank financial intermediation is capital markets, where investors generally pair long-term financial assets with long-term liabilities like insurance contracts and pensions, reducing the risk of financial instability. Other segments of the nonbank sector, such as the private credit market—that is, loans and similar financial contracts that originate outside the banking system or the publicly traded capital markets—are also rapidly growing.
Some financial observers and pundits are alarmed by the growth of private credit, since it moves credit origination outside of the highly regulated banking system to a more opaque sector of the financial system. UBS Group Chairman Colm Kelleher, for example, said last month that “since the [shadow banking] sector is not sufficiently regulated by definition, that is where you will probably see crises coming out.”
But given recent failures in the banking system, policymakers should be encouraging an even faster shift of financial intermediation to areas structurally safer than traditional banks. A private credit loan is typically a long-term loan to a risky corporate borrower funded with investors’ long-term liabilities. Critically, this arrangement better coordinates the timing and minimizes the risk mismatches fundamental to the banking model. Private-credit-fund investors are not promised the ability to redeem their investment at par on demand, unlike bank depositors—no runs, in other words. This creates a much more stable funding source for financial intermediation, without the associated risks of “financial contagion” inherent to the banking model.
To be sure, nonbank financial intermediation, too, can feature the maturity transformation and asset-price risk concealment that make traditional banking inherently unstable. Financial regulators should carefully scrutinize areas in the shadow-banking system—such as money-market funds advertising a floor on their net-asset value and certain types of hedge funds financing themselves in the short-term repurchase market—where these practices may be lurking.
It’s important to recognize, however, that regulators should address such risks outside the banking sector precisely because they resemble the underlying risks of banking. While shadow banking is on the rise, the banking system continues to originate a much larger share of the economy’s credit. Given the intractable risks posed by traditional banking, policymakers should support a broader move toward the shadow-banking sector to reduce the financial system’s instability.
Photo: Maryna Terletska/Moment via Getty Images