By: Susanna K. Tisa
January 15, 2014
For every action there is an equal and opposite reaction. This is certainly true of banking reform. Like squeezing a water balloon, regulators have pressed hard on traditional banks in the wake of the financial crisis, only to force demand elsewhere. The other side of the balloon is swelling, with all manner of nonbank entities rushing in to offer services that fill the demand - from alternative consumer options like payday loans, online lending and other small-dollar credit to commercial financing provided by business development companies, private investment funds and other shadow bankers.
While the government and industry remain focused on mopping up the last crisis, are we in fact setting up a new one? Â Unless we refocus attention on a broader picture that includes all the players, it is only a matter of time before the balloon bursts.
Shadow banks are not universally bad actors. In many instances, they are responding to public demand with products that demonstrate innovation and flexibility. Their number is growing fast. Over 20% of U.S. households are using alternative financial services such as payday loans at least some of the time. Small and midsize business loan originations from online lenders, merchant cash advance providers and other alternatives have grown a reported 64% in the last four years. The global shadow banking system grew by $5 trillion in 2012, to reach $71 trillion.
Consumers and businesses have turned to these lightly regulated alternatives, usually at much higher cost, as regulated mainstream banks are discouraged from lending to anyone but the most creditworthy. Policymakers say they want to bring "underbanked" young adults, immigrants, entrepreneurs and other groups into the traditional banking system for safer consumer options, small-business growth, a sound banking system and other laudable reasons. But today's rules and aggressive enforcement work against these goals.
Banks that attempt to innovate in order to serve struggling businesses and underserved consumer groups find themselves boxed in by risk aversion. Scores of new examiners hired in the past few years have been trained from manuals and checklists and are not yet sufficiently experienced to discuss and analyze the nuances of new service offerings. More experienced examiners may be able to make such distinctions, but are unlikely to be rewarded for being flexible or creative in applying guidance on a case-by-case basis.
The consequences are not to be taken lightly. For example, banks that have ventured to create quality small-dollar, short-term consumer credit products such as deposit advances have been answered with heightened regulatory scrutiny and reputational risk, with headlines touting a "Crackdown on Bank Payday Lending." This has been the case even when a bank's product is wrapped in a life-cycle approach including customer meetings, integration with other bank programs and a financial literacy component.
In commercial banking, given tightened underwriting and risk-rating guidelines, asset-based lending has, in large part, moved outside the regulated banking sector. Lending to customers without pristine credit records can be difficult, distracting and costly when a decision to include additional terms that protect the bank can result in a fair lending violation. Entire business lines, such as letters of credit, will likely be jettisoned in favor of smaller balance sheets.
Meanwhile, because of the sheer number and ease with which myriad types of alternative services can be launched in the shadow banking world, regulatory pronouncements of forthcoming oversight must be taken in context. There are simply not enough regulators, examiners or hours in the day to chase down, eradicate or sanction all the abusive practices that can emerge in this exploding market.
As demand migrates outside of mainstream regulated banking, innovation follows. Some nonbank and technology innovators are establishing best practices in business, technology and customer service, funded by deep-pocketed investors willing to take risks and cover compliance-related costs with their own capital.
The upshot is that policies and regulations intended to stem abuse and preserve the vitality of the banking system (ensuring banks are not "too big to fail") may in the end only shrink the economic activity conducted within the regulated banking sector. The risks have not been eradicated, they have only moved elsewhere.
As our metaphorical water balloon continues to swell, there must be constructive ways to take some of the pressure off and gradually redirect a portion of the demand back to regulated institutions. Banks and regulators should begin a new conversation, starting from the viewpoint of the disenfranchised consumer and business customer, and factoring in the likely economic scenarios that would unfold if these customers are not served by banks.
A practical conversation could be about setting "safe harbor" parameters that allow banks to design reasonable services for all American consumers and companies - not just the most financially robust - and replacing reactive regulation and "gotcha" enforcement with guided innovation.
Without a fresh approach, we will likely get all wet again when the water balloon finally bursts.