Money Stuff, by Matt Levine: Nonbanks

Old_Joe

If US regional banks are in decline, who will take their place? “Too-big-to-fail US megabanks” would be the obvious answer, and seems to be true. The biggest banks’ market power and implicit government support means that their funding is more stable and less rates-sensitive than the funding of regional banks. I am a JPMorgan Chase & Co. customer, and I occasionally check to see what rate they are offering on savings accounts, and it keeps being 0.01%, even as the Fed has raised rates. And I’m still a customer! (Not for savings though.)

But I argued last month that there is another, weirder answer, which is that the US financial system could separate the functions of deposit-taking (people want to put their money somewhere safe, earn interest, and be able to withdraw it at any time) and lending (people need loans to buy houses or run businesses). For a long time this has been sort of a niche idea beloved by some economists — versions of it are called “narrow banking” or the “Chicago Plan” — without ever being particularly close to reality.

But in 2023, quite a bit of the money that has left the regional banks has gone to money market funds that park that cash in the Federal Reserve’s reverse repo program, which now has about $2.2 trillion and pays about 5.05% interest. This is pretty close to narrow banking: Those money market funds will give retail customers an account that is, for most practical purposes, just money at the Fed.

On the lending side, meanwhile, DealBook reported this weekend that regional banks and even megabanks are going to have trouble making new loans, and:

That means businesses large and small may soon need to look elsewhere for loans. And a growing cohort of nonbanks, which don’t take deposits — including giant investment firms like Apollo Global Management, Ares Management and Blackstone — are chomping at the bit to step into the vacuum.

For the last decade, these institutions and others like them have aggressively scooped up and extended loans, helping to grow the private credit industry sixfold since 2013, to $850 billion, according to the financial data provider Preqin.

Now, as other lenders slow down, the large investment firms see an opportunity.

“It actually is good for players like us to step into the breach where, you know, everybody else has vacated the space,” Rishi Kapoor, a co-chief executive of Investcorp, said on the stage of the Milken Institute’s global conference this week.

But the shift in loans from banks to nonbanks comes with risk. Private credit has exploded partly because its providers are not subject to the same financial regulations put on banks after the financial crisis. What does it mean for America’s loans to be moving to less-regulated entities at the same time the country is facing a potential recession?

Institutions that make loans but aren’t banks are known (much to their chagrin) as “shadow banks.” They include pension funds, money market funds and asset managers.

Because shadow banks don’t take in deposits, they’re not subject to the same regulations as banks, which allows them to take greater risks. And so far, their riskier bets have been profitable: Returns on private credit since 2000 exceeded loans in the public market by 300 basis points, according to Hamilton Lane, an investment management firm.

I think this concern is a little backwards. For one thing, I don’t love the terminology. As Morgan Ricks, a leading scholar of shadow banking, puts it: “‘Shadow banks’ originally meant nonbank financial institutions offering deposit substitutes and I still think it would be better to stick with that terminology, rather than using the term to refer to any nonbank lender.” Lots of companies make loans, and it is better to use “shadow banks” to refer to companies whose liabilities make them look like banks, who borrow short-term to invest long-term and thus have the same fragility and run risk as real banks.[6] I have spent a lot of time over the last year or so describing various crypto firms (exchanges and lending platforms) as “crypto shadow banks,” because they are in the business of issuing deposit-like claims and investing that money in crypto hedge funds or whatever. (Well, they were in that business. Then they all had bank runs.)

But more important: The real risk of banking is on the liability side. What makes banks fragile is deposits. A private credit firm that raises money from investors in a locked-up fund, and uses that money to make idiotic loans that all go bust, is less risky than, well, a licensed bank that raises money from uninsured depositors and uses that money to buy safe US-government-backed bonds, like Silicon Valley Bank did. (Though: A private credit fund that leverages its fund with short-term borrowing is riskier, more run-prone, more like a bank.) What made SVB risky is that its funding could disappear overnight. If private credit reduces that risk, it’s probably fine for it to take more credit risk.