Banking Regulation, Innovation Responsible for Shadow Bank Growth

Regulatory burden on banks and technological improvements are likely the two most important factors behind shadow bank growth, a new paper says.

The increased regulatory burden faced by traditional banks has in part led to the growth of shadow banks and changes in global credit markets, according to a new academic paper published as a special feature in the MAS’ semi-annual macroeconomic review.

“In the aftermath of the crisis, tightened regulation, increased supervision and heavy fines and penalties prompted banks to cut risky lending, invest in more liquid assets and maintain higher equity capital,” the paper says.

“As a result, banks were reluctant to lend to less-than-stellar credit users. Shadow banks operating in a relatively lightly regulated environment seized the opportunity and have fulfilled the pent-up consumer demand.”

This observation is supported by empirical analysis which suggests that shadow bank activity grew in market share from 2008 to 2016 in regions where banks engaged in mortgage lending faced higher regulatory and supervisory pressure.

In the US corporate loan market, leverage limits and capital requirements were found to have restricted banks from participating in the riskiest deals, allowing shadow banks to step in.

Meanwhile in China, where the shadow banking sector holds about a third of all banking assets, the rapid growth in wealth management products (WMPs) over the last five years is also attributed in part to regulation.

According to the paper, improvements in technology have also enabled the growth of shadow banks in the form of fintech firms providing banking services to the same borrower pool as banks, more cheaply and conveniently.

Innovations in data science – including advances in AI, big data and credit scoring with digital footprints – have also enabled fintech lenders and P2P firms to better evaluate the likelihood of borrower default and underwrite loans for “credit-constrained” consumers. This has also led to the growth of so-called ‘fintech shadow banks’.

“Regulation on banks and technological improvements are likely the two most important factors behind [shadow bank] growth,” the paper says, offering a proposal for financial regulation that considers shadow banks and traditional banks side by side.

The full paper is available here.

The paper was authoured by Amit Seru, Professor of Finance at Stanford Graduate School of Business.

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