The rise of shadow banking, implications on the economy

Since the banking crisis of 2004, confidence in the financial system has been at a low and unenviable scale of fragility. Profound issues ranging from governance to structural composition of banks led to the inevitable collapse of several institutions, eroding depositor confidence along the way.

Ngonidzaishe Makaha

Contrary to popular assertion and belief that most of the issues bedevilling Zimbabwe’s banking sector were confined to the Zimbabwe dollar era, the same problems continue to be felt to this day. The outcome has always been the same.

Confidence in the banking sector is fragile!

Just like the retail sector has witnessed a new revolution in the form of vendors, the financial sector in Zimbabwe is facing its own in the form of shadow banks.

There is no clear cut definition for shadow banks but the general understanding of this term revolves around institutions that act within the scope of traditional banks but do so outside regulation and in some cases supervision. This concept was first coined by an economist called Paul McCulley back in 2007.

On a global scale, shadow banks hold assets approximately worth over US$70 trillion. In the United Kingdom, shadow banks are worth 400% of the country’s Gross Domestic Product (GDP) even though they are much smaller than conventional banks.

More germane to Zimbabwe, some so called “microfinance” institutions are now basically operating as shadow banks. In a rather mundane style, most microfinance institutions have played a distinct form of a zero sum game where fragility of depositor confidence in the mainstream financial system has been their splendent gain.

In general, microfinance institutions are supposed to confine themselves to the provision of microcredit to the lower end of the consumer chain, which is typically made up of low income groups and small businesses that are supposedly shun by mainstream banks.

On the contrary, most microfinance institutions are moving into spheres like structured finance, asset and trade finance, investments (often using pyramid schemes), securitisation and even mortgage based lending. This is the reason why they have become shadow banks in themselves because all such activities are preserved for the regulated mainstream banking system.

Of what scale are shadow banks corrosive to the economy?

The sub-prime mortgage crisis which culminated into the great recession of 2007-2009 was partly caused by some shadow banks which were actively trading in credit default swaps and other derivatives which were loosely regulated.

This in itself shows the great magnitude of convulsions which may be caused by shadow banks to the economy.

Shadow banks in Zimbabwe have the potential of crowding out mainstream banks in the provision of credit, particularly consumer and small business loans. In a normal economy financial institutions are supposed to make the bulk of their income through credit but with the current situation where shadow banks are sprouting at a greater scale, mainstream banks are surely poised to lose. According to the International Monetary Fund’s (IMF), Global Financial Stability Report 2014, shadow banks are outstripping mainstream banking sector growth in emerging economies and in a number of contexts they induce a soporific effect on financial intermediation.

Firms largely depend on mainstream banking and if the credit market sways to shadow banks the situation becomes pernicious to the whole economy.

Most microfinance institutions in Zimbabwe aim to generate returns as quickly as possible. The paradox of this notion is only understood by proprietors of that industry but two apparent facts may best explain this. It’s either they are horribly greedy or they are “rightfully” doing what has to be done in an economy oppressed by crisis and illiquidity. Lending rates in most shadow banks or microfinance institutions in Zimbabwe are pegged at an overwhelming 20%+ rate per month!! As if that is enough, most of these institutions have got loan tenures which don’t run beyond three months.

There is an extra ordinary divergence with the mainstream banking system where personal loans, for example, are priced at 15-22% per annum with most tenures tied to the loan amount.

This divergence creates a pricing matrix and gap in the credit market. Ultimately consumers suffer especially in Zimbabwe’s complex scenario where shadow banks hold sway. Mainstream banks at some point will be forced to review their pricing upwards and contract tenure so as to remain competitive in terms of income. Ultimately these price distortions stifle credit demand.

Shadow banks are not built on robust risk management policies and tenets. This in itself is a major threat to the financial system and the economy as a whole. Unlike mainstream banks which have risk management statutes and programs, although they sometimes flout them, shadow banks are mainly driven by profit and as such ignore certain risk mitigation measures. The Basel Accord stipulates that conventional banks hold certain amount of capital to cover operational, credit and liquidity risk but on the contrary shadow banks see no need of holding such buffer because every dollar they hold is for investment. As a result most of the shadow banks are susceptible to severe risk which can ultimately lead to collapse. A lesson on this is the great recession of 2007-2009 which saw the folding of many shadow banks in the developed world as a result of risk.

What safety net do shadow banks have?

This is a very pertinent question considering that insurance in matters to do with finance is important. It’s regrettable that the Reserve Bank of Zimbabwe cannot perform its lender of the last resort duties but all things being equal they should have been performing this function on mainstream banks. Apart from the central bank, most regulated commercial banks in Zimbabwe have institutional investors as shareholders, most of which are capable of acting as safety nets.

The picture is critically diametrically opposed in the case of Zimbabwe’s shadow banks where most of them are solely owned meaning that they are not tied to reliable and concrete safety nets.

It becomes a problem considering that most shadow banks in Zimbabwe are taking in collateral in the form of assets and property. What happens when they fold?

Conventional banks are subject to disclosure through various instruments like financial statements and annual reports. Shadow banks have no obligation to do so and as a result they can evade a lot of scrutiny and liabilities. This is especially corrosive in an economy like Zimbabwe where significant funds are tied up in shadow banks. No one knows their capital adequacy, profits, losses or the amount of bad loans they have.

The uncontrolled growth of shadow banks can also petrify the approach to which monetary authorities determine policy. It is apparent that shadow banks can lead to the tightening of banking regulations. Robert Shiller, a co-recipient of the 2013 Nobel prize for Economics argued that, Lehman Brothers, a US investment bank was a shadow bank and after it collapsed in 2009 the US financial system saw unprecedented financial regulations. Tightening of regulations clearly hobbles the dynamism of the financial sector especially when such petrification is induced by shadow banks.

In as much as shadow banking is corrosive, if conducted abstemiously and within proper rules it can be of fundamental importance to financial sector growth. However, because of the impudent manner in which most of them are run it is only wise to be cautious!

Makaha is an economist. These New Perspectives articles are co-ordinated by Lovemore Kadenge, president of the Zimbabwe Economics Society (ZES), e-mail kadenge.zes@gmail.com, cell +263 772 382 852.