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Why Fintech has absolutely nothing to do with shadow banking

Business People Working In A Conference RoomChances are some of the thoughts that come to mind when hearing the concept ‘Shadow Banking’ relates to bank opacity, excessive risk-taking, malpractice, negligence or fraud. Unsurprisingly, the term is often abused by banks which often place Fintech (particularly lenders) under such shadow banking umbrella.

The concept got itself a bad name as a symbol of the many failings of the financial system leading up to the global crisis. Indeed it was coined by Paul McCulley (former Pimpco’s chief economist) in 2007 when describing the securitisation of mortgages, which fell out of the supervisor’s sight. You may have probably heard of it in the news when referring to those reckless bank-like businesses that were not regulated as banks.

Regulators like the Financial Stability Board (an international body that monitors and makes recommendations about the global financial system) are trying to describe and define the economic activities that should fall under this shadow banking label. Although the concept is still evolving, the FSB has defined it as “credit intermediation involving entities and activities (fully or partly) outside the regular banking system” (e.g.  maturity/liquidity transformation, imperfect credit risk transfer and/or leverage). Once we have disentangled the meaning of this sentence, it becomes clear that Fintech has nothing to do with such activities.

This definition refers to non-bank institutions (i.e. non prudentially regulated institutions) that take funds and/or securities from investors and lend them out to borrowers. This pretty straightforward process could involve very complex financial instruments (derivatives, asset back securities, repurchase agreements…), but let’s keep it simple. Investors loan the money to the non-bank institution which in turn lends it out to the borrower. This activity is called credit intermediation and involves some credit risk for the intermediary institution since it would be the one exposed to the borrower’s potential default. Besides, this process usually involves maturity transformation, i.e. when the intermediary borrows short-term funds from investors and makes long-term loans. Such risky business requires a very exhaustive management of liquidity risks (otherwise the institution may incur maturity mismatches).

As you can see, these activities and processes (which again, I tried to simplify) are quite similar to what traditional banks do in their lending business. The main difference relies on the fact that funds attracted by the banks come not only from investors, but from retail depositors (who are covered by the deposit guarantee scheme and cannot take losses) which in turn are fueled to a great extent to the real economy (especially SMEs). That is why they are subject to much more strict (prudential) regulation and need to have liquidity and capital requirements.

Does Fintech fall under such a definition then? Although this ecosystem involves a wide range of different financial activities, it is pretty clear that a huge proportion of them (e.g. money transfer, FX, equity funding, retail currents accounts, mobile payments…) cannot be described as shadow banks according to the FSB’s definition.

And what about lending? Similar answer. Through peer to peer lending firms, which have evolved to become marketplace lending platforms, investors’ funds are matched directly to specific borrowers (which will vary depending on the risk appetite of the lender), so there is no credit intermediation. Thecredit risk is not held by the p2p institution but by every individual investor since each of them would be responsible for the potential default of the matched borrowers. This is known as credit disintermediation and the role of p2p institutions here is more limited to providing the agents with both a platform for undertaking this matching and a risk management service that analyses the trustworthiness and the credit risk of all the parties involved. What follows is that, unlike traditional banks (and unlike other credit intermediaries that would be classified as shadow banks), there is no money creation (i.e. no money multiplier), no possibility for maturity mismatches (since lenders and borrowers are synchronised) and no leverage. Bank runs are not possible, neither in the modern Northern Rock style nor in the classical bank run style since the lenders are not on-demand depositors. Again, investors risk their money according to their risk profile and are directly responsible for the losses of the borrowers.

Two conclusions can be drawn from this. First, that neither the Fintech ecosystem nor the Fintech lending industry can be defined as shadow banking according to the FSB’s definition. Second, that p2p lending regulation should differ from traditional banks’ prudential rules since both undertake different activities, are exposed to different risks and pose different risks to the economy.

This debate is independent of whether you defend that ‘Unregulated Shadow Banks Are a Ticking Time Bomb’ or that ‘Shadow Banks Are Not a Source of Systemic Risk’. However, since the term is still going to be used in the public and the regulatory debate, and has such a negative connotation (due to the name itself and its roots), the least traditional banks could do is try to be more rigorous when making use of it, especially since the reputation of other businesses is at stake.
This post was originally published at Philippe Gelis’ Linkedin Pulse

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