Shadow banking

What you need to know

July 20, 2017

At Mailey Rogers Group, we strive to guide, support and empower clients as they navigate their unique financial situations. We actively inform North Shore families about their wealth management options, and share financial news and resources that may interest them. Even those who take an active interest in their finances can be thrown by hot-button terms that pop up in the news overnight. One example of this is the buzz around shadow banking – an issue that’s been given a great deal of media coverage in recent months, but may not be something our clients are well-versed in. For this reason, let’s take a closer look at what it means and how it affects you.

Put simply, shadow banking refers to a system of non-bank financial institutions that conduct financial activities outside of federal regulations. Shadow bankers are intermediaries who conduct these financial activities, such as mortgage lending, investing and insurance services, without being subject to the same regulatory standards as a bank or bank-owned subsidiary. While these organizations are not illegal, they are associated with greater risk than a traditional financial institution.

Shadow bankers often do not have capital commensurate to the associated lending and borrowing risks – an issue that can have serious consequences. This was largely demonstrated during the 2007-2009 financial crisis. As stated in the Financial Post this past April, ‘the rise of complex off-balance sheet instruments, such as collateralized debt obligations and the soaring issuance of credit default swaps, fed the turmoil in financial markets, with severe ripple effects for banks and enormous taxpayer-funded bailouts.’

Additional regulations have since been introduced, but as the same article detailed, many risks remain. ‘[Shadow bankers] are not subject to the same capital, leverage and liquidity controls designed to protect banks and their customers, effectively allowing them to operate with higher risks. And they continue to innovate, finding new ways to expand credit and investment offerings, all outside of the realm of banking regulation.”

An area of shadow banking that has been widely criticized in recent months has been the mortgage industry. Use of shadow banking institutions has doubled in the past decade, going from a hold of approximately 6.7% of the mortgage market to an astounding 13%. To put that into greater context, the market is worth a total of approximately 1.4 trillion dollars. These are huge numbers!

So knowing the additional risk, why would anyone work with shadow bankers instead of a regulated financial institution? There are several reasons. First, these organizations are able to offer innovative and often tempting services due to their lack of regulation (again, at much higher risk). Secondly, as housing prices soared and regulations tightened up at the big banks, many individuals were unable to qualify for mortgages that would get them into their home of choice. This pushed them to plan B – the much riskier act of borrowing through an unregulated mortgage lender. Unfortunately, in this scenario, regulations meant to protect consumers from taking on too much mortgage debt have backfired somewhat in that those very consumers took on a high debt through a much riskier lender. This type of activity places strain on our entire financial system.

As Mailey Rogers Group is a part of Scotia Wealth Management – part of the Scotiabank family of companies – we are held to a very high regulatory standard. While we understand that our clients may own financial products outside of our recommendations, we feel an obligation to inform them of the risks associated with certain types of borrowing. The shadow banking industry is massive yet unstable, and not an avenue that we recommend dealing in. If you have questions about lower risk investing and borrowing options for your family, please contact us – we’d be pleased to offer information and guidance with only your best interests in mind.