Non-Bank Finance in America

A source of strength and possible weakness

Van Spina writes,

Put simply, direct lending is when a financial institution, other than a bank, lends money to company. Direct lenders usually make their lending decisions based on the borrower’s cash flow rather than asset base, the borrowers are typically mid-sized, and the deals are usually backed by private equity sponsors.

Pointer from Moses Sternstein. I strongly recommend the long post, which is a clear and well-written history of an important segment of finance in America.

Another term for direct lending is disintermediation. That is, instead of borrowers and lenders connecting via bank intermediaries, other lending institutions sprang up.

In my lifetime, much of this disintermediation was fostered by regulatory constraints on banks. In the 1970s and 1980s, when banks were tied down by ceilings on the interest rates that they could pay depositors, junk bonds took off. The Savings and Loan debacle of the 1980s was largely caused by regulatory distortions and was exacerbated by the S&Ls’ forays into junk bonds. In reaction, banking agencies imposed capital requirements that effectively penalized banks for making commercial loans—and instead pushed them into mortgage securities, which became the next crisis.

In most of the rest of the developed world, banks play a much larger role in finance. In Europe, Canada, and elsewhere, stock and bond markets account for a relatively smaller share of financial assets. Tyler Cowen points out,

On most days, Apple or Microsoft alone is more valuable than the entire stock markets of major European countries.

The United States has since its founding been characterized by populist hostility toward the banking industry. Until late in the 20th century, banks were not allowed to have branches in more than one state, and many states limited the number of branches that a bank could have. In some states, that limit was one.

While the American banking system was always crippled and fragmented, the stock market, the bond market, and various forms of “shadow banking” emerged to fill in the gaps. You can picture finance as a river, with bank regulations like little islands that have been placed in the middle. The river flows around the islands, in the form of direct lending and other methods of disintermediation.

In some sense, European banking puts financial decisions in the hands of elites. American finance, especially the stock market, is more democratic. As Tyler points out, we look really good at the moment. But we also looked good back when Irving Fisher said that stocks had reached a permanently high plateau.

Spina thinks that, on balance, direct lending is a good thing, because it better matches the nature of the assets and liabilities involved. Ordinary banks issue riskless, short-term liabilities (deposits) to fund risky, long-term assets (loans).

Banking enables households and firms to hold riskless, short-term assets (like checking accounts) and issue risky, long-term liabilities (like borrowing to buy a house or finance a business). The banks take the other side. That makes them subject to the risk of insolvency, due to bad decisions, adverse shocks, or bank runs.

If you don’t like bank insolvency and the government bailouts that tend to come with it, you can try to ban their usual form of intermediation. What you will get is disintermediation. Disintermediation means the emergence of shadow banks taking risks that are hard for regulators to monitor and control. If the regulators do manage to rein in shadow banking, then economic activity may be crippled.

Compared with banks, direct lenders generally put the onus on their liability holders to bear more risk and to commit funds for longer terms. That makes shadow banking more robust, all else equal.

But the incentives are always there for direct lenders to increase overall risk-taking and to drive that risk toward the government-backed banks. That is what happened with direct lending in the mortgage market in 2003-2007, when risky subprime loans were laundered into highly-rated tranches of mortgage securities, which received favorable capital treatment for banks, thanks to a regulatory standard known as the Recourse Rule.

Bank regulation is a classic example of what I call Sowell’s Law: there are no solutions, only trade-offs. The more tightly you restrict banks, the more finance will take place outside of the banking system. That could turn out to be a good thing. But it also could turn out to be highly unstable, because funding can dry up suddenly, as in the “run on repo” that took place in 2008. Or direct lending may, through clever risk transfer, end up loading the government-backed banking sector with unintended piles of risky assets, which also played a role in 2008.

My own suggestion for dealing with financial regulation is to introduce a layer of private-sector bank regulators. The rationale for this idea can be found in this essay. Please read that essay before posting comments.

substacks referenced above:

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Feb. 17, 2024 Weekly Recap & Good Reads

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The Definitive History of Private Credit