If shadow banking looks like a duck . . . 

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a research fellow at the University of Cambridge and author of the forthcoming book ‘Our Money: Monetary Policy as if Democracy Mattered’

Banking is the business of creating and disseminating credit. Bankers decide who gets a loan and on what conditions — and they possess this power by virtue of a deal made with the state.

In 1864, the National Banking Act gave banks chartered by the US government an effective monopoly over the creation of money. The government franchised its constitutional power to “coin money” to private bankers. In exchange, it required those same banks to hold its bonds in reserve, thus creating a guaranteed demand for government debt. This quid pro quo was a deal that most countries have seen fit to maintain ever since.

Around the same time, across the Atlantic, Walter Bagehot famously justified the private banking system on the basis of efficiency. He argued that private bankers were best suited to decide who should get a loan and on what terms because they had the relevant information based on local relationships.

Since then, conceptions of both the nature of banking and how to best regulate it have changed. During the period after the Depression, regulators became increasingly concerned with preventing bank runs and insulating deposits. They occasionally stepped in to establish guardrails for the loan decisions private bankers made, arbitrating which were and which were not legitimate bases for the determination of creditworthiness.

In the wake of the 2008 crisis, the focus of bank regulation shifted to the prevention of systemic risk. The US passed the Dodd-Frank Act, designed to make the sector safer and better capitalised, so that the government wouldn’t have to bail out any bank ever again (how’s that going?). One result has been a decrease in lending to borrowers deemed too risky or too much of a regulatory headache.

But there have long been non-bank lenders outside of regulation and new forms of shadow banking have stepped in to fill the gap. Shadow banks are those “non-bank financial intermediaries” that act like banks but aren’t regulated like them. Their profit-based appeal is clear — shadow banks can lend to “risky” borrowers without scrutiny.

The new boom industry of “private credit” is undeniably one form of this, but with its innocuous sounding moniker it manages to avoid the negative connotations that come with operating in the shadows. As an approach to credit origination, private credit paints itself as less speculative big bank and more local banker. Its loans are generally less levered and tend to have longer terms. Private creditors perform their own due diligence on potential loans, offer bespoke loan agreements and often hold loans to maturity. But in practice, these loans are often made to private equity owned companies and in service of distressed debt deals.

Critics of the shadow banking sector are many and varied but, generally, their regulatory position is simple: if it looks, acts and sounds like a duck, regulate it like a duck. Shadow banks should be regulated as banks. The question then presents itself: what does it mean to regulate a duck?

Historically, regulating private money creation was a nuanced dance, involving a constant exchange of information between banks and the government, and regular changes to the conditions of franchising. After all, banks were considered franchisees of governments and acted on strict terms set by them.

Today, things have changed. Bank regulations largely focus on preventing the emergence of systemic risk. Supporters of the private credit industry argue that one consequence of its more “traditional” approach to credit creation and allocation is that despite its size and rapid growth, it is unlikely to emerge as a source of systemic financial risk. So far, regulators seem to agree. But at $1.5tn, the sector is certainly big enough to have a systemic effect.

When things operate in the shadows, they are hard to see but what is clear that decisions about who has access to credit and on what terms are increasingly taking place outside the regulatory reach of the state. As political economist Oddný Helgadóttir put it, shadow banking is the “global culmination of a march towards the deregulation and depoliticisation of credit allocation and credit creation.”

The quid pro quo basis on which the private banking system was based is therefore dissolving while the shadow banking sector profits massively from the power to create money in the form of credit. The question we should be asking is: what are we getting in return?