Beware the Shadow Banks

There is a curious duality in banking today when it comes to the credit cycle. The U.S. economy continues to grow, albeit at a slower pace than in the recent past, recession fears have generally calmed after three consecutive interest rate cuts by the Federal Reserve, and bank asset quality remains quite good.

And yet there is also growing concern that competition in the commercial loan market is getting out of hand.

During Home BancShares Corp.’s third-quarter earnings call, CEO Johnnie Allison complained about the irrational underwriting practices that he sees going on in the commercial loan market today. “It appears to be a race of the dumbest because they” – by they, he means other lenders – “are just giving the stuff away.”

Allison pointed his finger at other “stupid bankers,” but also – ominously – the so-called shadow banks.

The shadow banking system is made up of nonbank lenders including mortgage originators, business development companies and various types of investment funds. The sector is largely unregulated compared to the highly regulated banking industry.

Shadow banks have developed an appetite for commercial loans, which is helping to fuel the competition.

Concern about the impact of shadow banks was on full display in September at a one-day credit conference hosted by Kroll Bond Rating Agency. “I think the consensus in the conference, and our view here at KBRA, is that we’re still in the benign part of the credit cycle,” says Senior Managing Director Van Hesser.

And yet there was also fear about the impact that nonbank lenders could ultimately have on the credit cycle. “If you’ve got the shadow banking system being very aggressive, those losses that ultimately arise are going to impact market confidence, which in turn could trigger tighter credit conditions and contribute to an economic slowdown,” Hesser says. “That’s the bearish path that has a lot of people, whether you’re a banker or an investor, [concerned]. That’s the source of the anxiety.”

If this sounds like déjà vu all over again, that’s because it is. Nonbank mortgage originators were significant contributors to the subprime mortgage boom that ultimately resulted in the financial crisis 11 years that nearly brought down the global economy.

The irony is that, in response to the last crisis, federal bank regulators issued tougher guidance for leveraged lending in 2013, which Hesser says drove a lot of that activity out of the traditional banking sector and into the shadows. (Leveraged loans are high-rate loans made to corporate borrowers with credit ratings that are below investment grade.) “And given the length and strength of the economic expansion, there was a real opportunity for nonbank lenders to come into the commercial loan space and fill that void that the regulators helped push out of the banks,” Hesser says.

There is shopworn expression in banking that remains true: The worst loans are made in the best of times. An underpriced and poorly structured loan underwritten today might be the first credit to go bad a few years down the road when the economy falters. And while recessionary fears might have abated for now, it would be naïve to think that the business cycle has been tamed.

“If you look at the asset quality data, it’s still very, very positive,” Hesser says. “But we’re starting to see a disproportionate amount of weaker credit deterioration coming out of the nonbanks, [and] that’s what we’re focused on.”

Allison at Home BancShares, who has a reputation for bluntness, says while there is a lot of pressure on banks to grow, his lenders will remain disciplined because they don’t want to be “characterized as stupid bankers.”  “This is a really dangerous time for banks,” he says.