As banks retreat in the wake of the financial crisis, “shadow banks” are taking on a growing share of their business, says Edward McBride. Will that make finance safer?

IT WOULD BE hard to find a company with a greater sense of tradition than Hall & Woodhouse brewery. Founded in 1777 in the English county of Dorset, it is still based just a few sheep-speckled hilltops from the village where it began. It is also still owned and run by descendants of its founder, Charles Hall (the Woodhouses married into the family in 1847). It has been brewing on the same site, using water from the same wells, since 1900.

The firm’s grand Victorian brewery complex (pictured above), with its clock tower, turrets and red-brick smokestack, has been preserved with pride. A museum inside displays ancient brewing equipment, a stuffed badger and sepia-toned pictures of the Halls and Woodhouses of yore, alongside records from Hall & Woodhouse’s earliest days. They show, for example, that on October 22nd 1779 the firm paid a Mr Snook 18 shillings for seven quarters (roughly 90kg) of barley. Even the names of the beers, such as “Fursty Ferret” and “Blandford Flyer” (said to help ward off the insects that plague local fly-fishermen) are steeped in rural nostalgia.

Until this year the firm’s financial arrangements were equally traditional. It never listed its shares or issued a bond. Instead, whenever it needed to finance a big new project, such as the gleaming new brewing facilities that abut the Victorian ones (now converted to offices), it borrowed money from a bank. Given its steady income, its low level of debt and its pristine credit record, it never had any trouble getting a loan, says Martin Scott, the firm’s finance director.

Hall & Woodhouse needed more reliable long-term creditors, so it reduced its bank borrowing and turned to a shadow bank

The financial crisis changed all that. When in 2010 Hall & Woodhouse asked its main bank, the Royal Bank of Scotland (RBS), to renew its regular £50m ($84m) line of credit, it got a nasty surprise. The management of RBS had been far less prudent than that of Hall & Woodhouse, borrowing heavily over the preceding years to expand its business at breakneck speed. When its own credit dried up, it was forced to turn to British taxpayers for a £45 billion bail-out and began a frantic retrenchment, shedding £1 trillion in assets and cutting its staff by 40,000. The bank told Hall & Woodhouse that it would renew its line of credit for only three years instead of five, and at a sharply higher rate of interest.

Mr Scott balked at this and arranged a similar loan facility at another, less troubled bank, but the incident unsettled him and the owners. They decided they needed more reliable long-term creditors, so they reduced their bank borrowing and turned instead to a shadow bank—a financial firm that is not regulated as a bank but performs many of the same functions (see article). The one they picked was M&G (the asset-management arm of Prudential, a big insurance firm), which offered them £20m over ten years.

Shadow banking got itself a bad name during the financial crisis, chiefly in the form of off-balance-sheet vehicles that were notionally separate from banks but in practice dependent on them. Their assets were often securitised loans that turned out to be much riskier and less valuable than expected.

These vehicles were meant to expand credit, and thus bolster the economy, while spreading the risks involved; at least that was the justification for excluding them from the banks’ liabilities and allowing them to hold relatively little capital to protect against potential losses. Yet when they got into trouble, the banks had to bail them out on such a scale that many of the banks themselves then needed bailing out. The vehicles turned out to be an accounting gimmick dressed up as a service to society.

Worse, they generally relied on short-term funding from money markets, another form of shadow banking. Money-market funds, in which businesses, institutions and individuals invest spare cash for short periods, involved a different sort of subterfuge. Although all lending is inherently risky, they presented themselves as risk-free. Their shares were supposed to retain a steady value of $1, so when one of the biggest funds announced at the peak of the crisis that it would have to “break the buck”, panic ensued.

The flight from the money markets added to the troubles of banks and other financial institutions that relied on them for short-term borrowing. They had made big losses, were struggling to borrow and so found themselves unable to repay depositors, bondholders and other creditors. That left taxpayers on the hook, both because governments in most rich countries guarantee small bank deposits and because they were reluctant to let big banks fail, for fear that the financial system might fall apart altogether.

Banks have since had their room for manoeuvre severely restricted to make them safer. New accounting rules have made it much harder for them to park suspect assets in off-balance-sheet vehicles. In effect, lending by banks must be labelled as such. And they are now obliged to hold much more capital to help absorb losses in case another crisis strikes.

There are only three ways for them to increase capital relative to their loans and other assets: by raising more of it, by cutting costs or by trimming lending and investment. Banks around the world have been doing all three for several years, to the dismay of firms such as Hall & Woodhouse. They have an especially strong incentive to curb long-term loans to business, since regulators not only require them to hold more capital against them but also to fund long-term loans in part with long-term borrowing, which is more expensive than the fly-by-night sort.

As a result, bank lending to businesses in America is still 6% below its 2008 high. In the euro zone, where it peaked in 2009, it has declined by 11%. In Britain it has plummeted by almost 30%. Bank lending to consumers has shrunk by less, in part because most of it consists of mortgages, which take some time to unwind (see chart 1). But all in all, big Western banks have shrunk their balance-sheets by trillions of dollars.

This retreat of the banks has allowed the shadow banking system to fill the ensuing void. Mr Scott of Hall & Woodhouse, for one, is happy to be able to borrow from somewhere other than a bank. Although his arrangement with M&G is slightly more expensive and less flexible than the shorter-term credit he is still getting from the banks, he says it costs far less in terms of managers’ time and allows the firm to plan for the longer term. British banks, he says, simply do not offer ten-year loans to firms like his any more because they cannot make a profit on them.

M&G has no such concerns because it is not considered a bank, nor regulated as such. The money it has doled out to Hall & Woodhouse comes directly from institutional investors, including Prudential and various pension funds, which have given M&G £500m to lend to mid-sized British businesses. All the proceeds from the loans go to the investors, who must also bear any losses; M&G simply administers the portfolio of loans on their behalf and charges them a fee. Whereas a bank intermediates between savers and borrowers by entering into separate transactions with each, with all the risk that entails, M&G is merely a matchmaker, with no “skin in the game”.

For all their residual worries about shadow banking, regulators like this arrangement, because in some ways it makes the financial system safer. If the economy stumbles, causing corporate earnings to slide and thus increasing the number of defaults on loans such as Hall & Woodhouse’s, any losses will fall squarely on the institutional investors who put up the money.

It is not just M&G that has benefited from the banks’ retrenchment. The business of “direct lending” or “private debt” (by analogy with private equity) is booming. Investment funds that make loans of this sort raised $97 billion last year worldwide and hope to raise a further $105 billion this year, according to Private Debt Investor, a magazine. Another similar but exclusively American category, business development companies, grew tenfold between 2003 and 2013, according to the Securities and Exchange Commission. At the end of last year they held assets—mainly loans to businesses—of roughly $63 billion.

Don’t bank on it

And private debt is only one form of lending that takes place outside banks. Bond markets—by far the biggest source of non-bank financing—continue to grow even as bank lending shrinks. In 2007 the value of all outstanding corporate bonds issued by American firms was just under 29% of GDP; by last year it had risen to over 42%, according to McKinsey. In South Korea the figure rose even more dramatically, from 23% of GDP to 48%. Globally, corporate bond-issuance doubled between 2007 and 2012, to $1.7 trillion, as firms everywhere took advantage of extraordinarily low interest rates.

Money markets in the rich world seized up during the crisis and have not yet fully recovered, but in China and other emerging markets they are growing rapidly. A money-market fund launched last June by Alibaba, a Chinese e-commerce giant, attracted 500 billion yuan ($81 billion) in its first nine months.

Peer-to-peer (P2P) lenders—websites that match savers with borrowers—are also growing like topsy, albeit from a tiny base. The value of loans chaperoned by Lending Club, the biggest such website, has doubled every year since its launch in 2007 and now totals over $4 billion. New firms are springing up the world over to cater to all manner of niches, from short-term loans for property developers to advances against unpaid corporate invoices.

The Financial Stability Board (FSB), a global financial watchdog, reckons that shadow lending in all its forms accounts for roughly a quarter of all financial assets, compared with about half in the banking system. But it excludes insurance and pension funds from its calculations; add those in, and shadow banking is almost on a par with the better-lit sort.

According to the FSB, shadow lending has grown by leaps and bounds in recent years. The watchdog estimates that such loans in the 20 big economies that it tracks rose from $26 trillion in 2002 to $71 trillion in 2012 (see chart 1 above). The FSB’s data show bank lending growing at much the same pace, but that is partly because, in the teeth of the crisis, regulators forced financiers trying to game the system to reclassify much shadow lending as bank lending. The FSB’s data confirm that the sorts of shadow lending that worry regulators, particularly off-balance-sheet vehicles, have atrophied, whereas the sorts that please them, including direct lending, have rocketed.

The process of shifting lending out of the banks and into other financial institutions has long been underway in America, where bond and money markets are well-developed; banks there now account for only a quarter of loans. But it is also gathering pace in Europe, where banks have been especially hard hit by the crisis, and in other parts of the world.

And lending is just one area in which banks find themselves on the back foot. The same combination of stricter regulation and increased competition is hurting banks in other areas that used to be seen as an integral part of their business, such as payments, the mundane but important business of transferring money from one account to another.

The most common and lucrative way for payments to be made in the rich world is through credit or debit cards. Regulators in America and the European Union have been putting limits on the fees banks can charge for such transactions. At the same time all sorts of new payment technologies are springing up, from “virtual wallets” that claim to make the physical sort redundant to Bitcoin, a scandal-prone electronic currency that nonetheless has the potential to turn the business of sending money upside down, cutting banks out of the process altogether.

New ways to pay

The trading of bonds and other financial instruments—the mainstay of investment banking—is another area where banks are pulling back in the face of new technology, new rivals and new regulatory constraints. Rules that bar or deter banks from trading on their own account, and make it more costly to do it for others by increasing capital requirements, have already resulted in a big drop in the volume of bonds held by investment banks. Other regulations now being introduced are pushing the trading of derivatives onto public exchanges, greatly reducing banks’ influence over the business and the profits they can make from it. Regulators are also discouraging banks from dealing in physical commodities in any form.

Other financial institutions are cheerfully abetting the regulators’ drive to wrest a lot trading from banks. The banks’ big customers—chiefly asset managers of various kinds—are trying to create systems to trade more among themselves, cutting out the middlemen. The shift away from fast-talking salesmen towards electronic trading is also bolstering exchanges, technology firms and data providers at the banks’ expense.

Similarly, asset management (which this report will not cover in detail) has been growing much faster outside the banking system than within it in recent decades. The crisis accelerated the trend, as some banks sold their asset-management arms to raise money. Regulation designed to protect investors from conflicts of interest makes it hard for a big bank to do business with an in-house asset-manager, reducing the opportunities for savings or cross-selling. And new technology is making it easier for firms and individuals to find and invest in a range of financial instruments without the help of a bank. The world’s biggest asset manager, BlackRock, with about $4 trillion under management, is now considerably larger than the biggest bank, the Industrial and Commercial Bank of China, with assets of roughly $3 trillion. Before the crisis the reverse was true.

This does not mean that banks are about to fade away; only that their relative weight in the financial system is diminishing as other financial institutions proliferate and grow. Indeed, that is largely what regulators intend. They want to see banks shrink and welcome the transfer of risky assets to other parts of the financial system. This special report will chart some of that transition and consider the potential pitfalls.

Whatever the consequences, however, this new world is here to stay. As Mr Scott of Hall & Woodhouse says of shadow lenders like M&G: “The banks are going to have all their best customers taken by these people.”