By Benny Sun
“Truth is like poetry and most people… hate poetry” - The Big Short (2016)
The Great Recession of 2008 has become one of the darkest moments in modern history, permanently shaking up millions of American households and international markets. Within a few short months, America experienced a total financial meltdown with the bankruptcy of investment banks such as Lehman Brothers, foreclosures of 10 million homes, and the wiping out of 20 trillion dollars in total American household assets. Unfortunately, at the heart of America’s crisis was criminal negligence and sheer greed from politicians and higher-ups in the banking sector. This is because while major banks were bailed out by the US government, the brunt of the economic burden was placed on the very poor. Although the Dodd-Frank Wall Street Reform sought to address the recession’s root cause, new trends in global banking seemingly seek to only replicate the same recklessness prevalent among banking institutions prior to 2008. Here, this article will address the main culprit: shadow banking, now a 52 trillion dollar global industry which represents a 75% increase since 2008
The shadow banking system, often in the form of hedge funds, has the same goal as traditional banks of providing access to loans and liquidity. However, there are numerous differences between both categories. Foremostly, shadow banks, because they don’t provide typical deposits, are subject to little or no regulations, often only required to register and have assets worth around 150 million dollars. Consequently, shadow banks are more easily able to loan towards unqualified borrowers considered too risky to loan to (which under certain conditions can expand economic growth and financial access). However, as in the cases of 2008, mass defaults across these loans could trigger bank bankruptcies as well, as these banks often profit off the promise of future money, rather than their current financial situation.
Moreover, shadow banks also lack access to government safety nets like deposit insurance or central bank funding, making their operations considerably riskier. Instead, these corporations rely on money from short-term investors to fund these operations. Thus, as unregulated institutions, many shadow banks simply skirt away from the rules designed to avoid a financial crisis. For instance, as their investment is reliant on investors, any market downturn could decrease investor confidence which forces shadow banks to either shut down or sell off all of their assets at depressed prices to return their money to investors, causing a downward price spiral in derivatives, bonds, and stock markets. Overall, Economist Paul Krugman demonstrates how shadow banking creates vastly more volatile markets and economies, concluding that it “makes the good times better, but the bad times far, far worse”.
An implication of shadow banking in the United States has been its major role in procuring a private debt and loan conundrum, a ticking time bomb for America’s economy. Economic columnist Steven Pearlson specifies that the increased accessibility of loans in the market is only fueling increasingly severe credit bubbles such as auto loans, student loans, and credit card debt. The reason why risky lending is so harmful is that while providing this capital can prove vital to low-credit households and companies if they are unable to pay it back and are forced to issue a default, the shadow bank loses precious money for operations and investors. Multiply this by the thousands and an economic catastrophe becomes tangible, such as the case of increasing mortgage defaults and the popping of the Housing Bubble that preceded the 2008 recession. Even after recent legislative attempts to regulate the Shadow Banking industry, much of the industry is still considered to be as risky as before and still as dangerous.
Alarmingly, these effects of shadow banking have already manifested in debt markets. A recent economic report shows that the private debt market as a result of shadow banking has tripled, accounting for a 1.2 trillion dollars of American debt. This only breeds instability for businesses and individuals, as any economic shock, such as mass layoffs, lower spending, or dips in the stock market, can push corporations into insolvency or families into bankruptcy which makes them unable to pay off their debts or loans. For this reason, household debt is seen as a good indicator of the future economy, with the last five economic recessions being preceded by high levels of household debt. Even now with the Coronavirus pandemic, stock markets are cascading to all-time low never seen before since 2008, members of the Financial Stability Oversight Council have identified shadow banks as a major risk amid economic anxieties. Thus, the Coronavirus will simply compound the difficulty of keeping shadow banks afloat as they face a new financial crisis.
Overall, Bond Ratings Agency DBRS is calling on federal legislators to increase regulations on the shadow banking industry, as existing loopholes and lack of oversight could generate incidents of rapidly recurring recessions. They conclude their letter with a very clear and price message: with the Coronavirus pandemic around the corner, the banking industry is “not ready to handle an economic crisis” and Americans should be “very worried”.