While its role was sharply curbed in the wake of the financial crisis, the U.S. shadow banking sector is growing once again, says TD Economics in a new report.
In its report, TD says that the shadow bank sector — which includes vehicles such as asset-backed commercial paper (ABCP) conduits, credit hedge funds, finance companies, government-sponsored enterprises (GSEs), money market mutual funds (MMMFs), securities lenders, and structured investment vehicles (SIVs) — developed into an important source of credit to the economy before the financial crisis hit.
However, the crisis exposed the flaws in shadow banking, highlighted the potential for broader financial sector contagion, and has resulted in increased regulatory oversight for both traditional and shadow banks, it says — and the shadow banking sector contracted rapidly in response.
Now, after five years of declines, shadow banking began to grow once again last year, TD says. “Driven by rising demand for credit from a growing economy, together with competitive advantage stemming from increased regulatory burden on large deposit-taking institutions, shadow banks together with smaller deposit-taking institutions are increasingly active in credit intermediation,” it says.
Looking ahead, it sees strong growth potential in the sector too. “While shadow banking has not escaped increases in regulatory oversight, its growth prospects remain high, and are further accentuated by future financial innovation. Shadow banking is on the rise again and will continue to evolve in response to the changing regulatory climate,” the report says.
Indeed, it expects shadow banking to continue growing, “as increasing demand for credit from a recovering economy together with more stringent regulation of traditional banks pushes credit intermediation into the ever evolving shadow banking system.”
TD notes that shadow banking is perpetually evolving, making it difficult to forecast what it will look like in the future. Indeed, it says that regulatory reform has increased the costs of ABCP and ABS issuance. Also, growth in money market funds may be slowed by previously enacted limits, it says. And, with GSE reform still possible, that sector may be affected too.
“Given the role that it played in helping fuel the credit bubble, the recovery in shadow banking is bound to attract considerable attention. This has put shadow banking under greater regulatory scrutiny. But, even with more oversight, there is good reason to believe that this sector will continue to play a core role in the financial system and it will expand in the years ahead,” it concludes.