A shadow bank is defined as a non-bank entity that provides lending services similar to a traditional bank but does so outside the traditional regulatory environment in which a commercial bank must operate. The main differentiator between shadow banks and traditional banks is that shadow banks are prohibited from taking deposits as they do not hold a banking licence. Shadow banking entities include, but are not limited to, hedge funds, money market funds, structured investment vehicles, exchange-traded funds, private equity funds, securitisations and other asset-backed financing vehicles.
Why is there a need for shadow banks in the corporate world? Shadow banks can provide credit to clients more cost efficiently than traditional banks as they do not have to comply with the rigorous regulations enforced on those banks. Corporate clients seek to limit costs in financing their operations, the result of which is financing through special vehicles such as asset-backed securitisations. For instance, a company would sell off its debtors to a securitisation vehicle which would then repackage those debtors as bonds, which would then be sold to investors. The company obtains financing while the investors will obtain regular payments as the special purpose vehicle receives interest and capital payments from debtors.
These special purpose vehicles were a major factor in the 2007-2008 financial crisis. The assets that backed the debt fell in value; to the point where the debts could no longer be serviced based on the underlying assets. In the aftermath of the crisis, governments called for far tighter regulation over these special purpose vehicles specifically used for debt financing purposes. Due to this, traditional banks cut back significantly on these types of lending structures.
Six years on from the crisis, countries around the world still struggle with low growth. This is mainly due to the inability of traditional lenders to lend as they are still attempting to recapitalise their balance sheets to align with current regulations. Some might say that commercial banks have now become far too risk averse and the banking industry has been hindered by over-regulation. Shadow banks are now seen in some circles as possible growth initiators as they can provide lending where traditional banks will not, due to risk, or cannot, due to regulation. The European Commission has intimated in proposals that they would make use of non-traditional lending facilities to fund long-term investments to boost Europe’s economies. This can be seen as a rehabilitation of sorts for the shadow banking industry.
In the consumer market, shadow banks provide credit to customers that traditional banks would normally not lend to, as they are seen as too risky. Specifically, this would be the low income market where a person’s credit worthiness might be poor. Traditional banks would not usually lend to these customers as they would not fit the required risk profile and the imputed costs would be too high. Shadow banks will provide financing but at far higher interest rates than traditional banks and/or would require significant collateral for amounts lent.
The upside to this form of lending is that it boosts economic growth, as even low income earners have access to credit and continue to spend on goods. The downside is that the consumers that would make use of these lending facilities are normally financially illiterate and not aware of the actual cost implications of the money borrowed. They only realise later that they can’t afford the credit provided, which leads to further credit and finally they land up in a constant debt cycle. It has been noted in the past that the levels of unsecured debt in South Africa are extremely high especially for low income earners.
The National Credit Act (NCA) was implemented to, amongst other things, regulate credit provided to consumers and to also provide a way to re-organise debt due to over-indebtedness. Shadow banks are obliged to register with the National Credit Regulator (NCR) who regulates in terms of the NCA. Thus, at least in South Africa, shadow banks providing credit to consumers are regulated in some way. However, some have said that the current NCA is not rigorous in terms of the current affordability calculations applicable when a consumer requests credit finance. A NCA 2 Act has been muted, which will address this issue and further control the amount of lending to consumers.
Shadow banking is a far reaching industry which has implications for all lending in South Africa. In terms of consumer market lending, which can be seen as the most risky form of lending in the shadow banking space, regulation is in place and will, more than likely, be strengthened in the future. However, will further regulation have the desired impact or simply impede future economic growth?