Low interest rates and the surge of shadow banking
In the mortgage market, the share of originations by shadow banks has surged since the Great Financial Crisis. Economic research has focused on two main factors that explain such surge: a) “regulatory arbitrage” which explains the rise of shadow banks as a byproduct of tighter regulation on traditional banks and b) technological advances that have improved the quality of online platforms and the processes for automated lending and facilitated the proliferation of shadow banks. In this paper, Sarto and Wang argue that there is a third factor that might explain the surge in shadow banking in the mortgage market, namely the secular decline in interest rates. The authors argue that a decline in interest rates has an asymmetric impact on banks and non-banks:
- Low nominal interest rates hurt bank profitability by compressing the spreads they earn between assets and liabilities. This spread between market rates and deposit rates is a major source of profits for banks when interest rates are high, but also a fragile one that vanishes as interest rates approach zero. This compression of the spread leads to lower loan growth, for both commercial and residential lending.
- Shadow banks, on the other hand, have no access to cheap deposits, hence they must fund themselves at higher rates than their bank competitors. Since the spread between market rates and deposit rates is higher at high interest rates, the competitive disadvantage faced by shadow banks is more severe in a high-rate environment. Conversely, as interest rates fall, the funding disadvantage of shadow banks disappears, which helps them grow relative to traditional banks.
Our main results show the response of shadow banks to the contraction in traditional bank lending. We find that [US] counties with more exposed banks saw a stronger increase in the shadow bank share, by around 10% for every additional 100 bps in the exposure of banks present in the county, weighted by local lending. This result supports the idea that shadow banks gained significant territory in housing markets where banks were hurt by the decline in interest rates.
The Secular Decline in Interest Rates and the Rise of Shadow Banks
Authors: Andrés Sarto, Olivier Wang
From: New York University
High interest rates and the surge in mortgage lending by shadow banks
In this paper, Agarwal et al. highlight the role of mortgage servicing – the provision of administrative services for a loan from the time the proceeds are dispersed to the borrower until the loan is paid off – of shadow banks in generating non-deposit funds for lending:
By owning the claim to service a mortgage for its duration – i.e., a mortgage servicing right (MSR) – a shadow bank holds an asset whose value is positively correlated with interest rates and that can be pledged as collateral for external funding. When interest rates rise, prepayment speeds decline, and the expected duration of outstanding loans lengthens, increasing the value of MSRs. At the same time, servicing provides shadow banks with a relatively stable stream of fixed income that is typically unaffected by changes in interest rates. Thus, for shadow banks, servicing acts as a natural hedge against interest rate shocks and attenuates the effects of monetary policy on their mortgage lending.
This increase in mortgage originations by shadow banks when interest rates rise has a major drawback: the authors estimate that through the mortgage servicing mechanism, the rising share of shadow banks has weakened the pass-through of monetary policy to aggregate mortgage lending.
The Secular Decline in Interest Rates and the Rise of Shadow Banks
Authors: Isha Agarwal, Malin Hu, Raluca A. Roman, Keling Zheng
From: University of British Columbia, Vanderbilt University, Federal Reserve Bank of Philadelphia
