Shadow banks – non-depository lenders – have disrupted every facet of traditional banking activity from lending to payments. Within the $10 trillion U.S. residential mortgage market, for instance, shadow banks happen to be originating over fifty percent from the total new loans each year since 2017, and 6 from the largest 10 mortgage brokers were shadow banks (Buchak et al. 2018). Despite their central role in evaluating rules and policies, evidence about how these intermediaries are funded is quite limited (Jiang et al. 2020).
Within my recent working paper, I personally use new data on shadow banks’ funding to document a vital distinguishing feature of the funding sources: shadow banks are funded through the very banks they contend with in originating mortgages. Banks within-house mortgage origination provided about 70% of total warehouse lines of credit – a kind of short-term debt – received by shadow banks from 2011 to 2017 (figure 1). In 2017, in regards to a trillion dollars were flowing with these warehouse lines which have total credit limits of $570 billion. These persistent warehouse funding relationships are clustered between your banks and also the shadow banks that originate mortgages within the same geographic regions and therefore compete for the similar local mortgage borrowers. Then i study how this upstream funding relationship between banks and shadow banks affects competition within the downstream mortgage origination market.
A bar chart composed of Shadow “Mortgage Banks” “Non-Mortgage Banks” and “Others”
There’s two countervailing forces in banks’ decisions to increase funding to some shadow bank when banks have upstream market power. Both forces decrease the competition within the downstream market. Around the one hands, lending to shadow banks lowers a bank’s profits within the downstream market. This cannibalization funnel induces banks to lower upstream lending to shadow banks, reducing competition within the downstream market. However, market power within the upstream market enables the financial institution to partly capture shadow banks’ mortgage lending profits. Through this funding funnel, banks have stakes within the shadow banks and therefore internalize the price of competition within the downstream market.
Empirical evidence shows that banks have market power within the upstream warehouse lending market. I reveal that these relationships are pricey to substitute by exploiting a clear, crisp, unanticipated oil cost decline. This decline led to differential internet worth shocks to banks according to their balance sheet contact with the gas and oil industry. Following a shock, uncovered shadow banks’ price of funding elevated in accordance with those of other shadow banks, suggesting that replacing the connection is pricey. The shock propagates into shadow banks’ mortgage origination within the downstream market. Uncovered shadow banks elevated their mortgage rates of interest within the downstream market and originated less home loans than other shadow banks within the same county in the same time. The outcomes imply banks’ market power within the upstream funding market spills to the downstream mortgage market.
In conjuction with the cannibalization funnel, a financial institution is less inclined to give loan to shadow banks in counties where its very own mortgage origination market shares are high. They are markets where the cannibalization effect could be most unfortunate. In conjuction with the funding funnel, a financial institution that funds more shadow banks inside a county charges greater rates within the downstream market, suggesting that it doesn’t compete too seriously with shadow banks, and rather appropriates the rents within the upstream market.
Then i develop a quantitative model and reveal that banks’ upstream market power softens competition within the downstream mortgage origination market, lowering consumer surplus by $14 billion within an average metropolitan record area (MSA). This effect is nearly double in MSAs with one standard deviation greater downstream mortgage market concentration. Thus, the expense of banks’ warehouse lending market power are largely borne by households whatsoever competitive downstream mortgage market who’re already struggling with restricted use of credit. It might appear the added competition from shadow banks is needed these borrowers most. Yet, shadow banks’ expansion is restricted during these areas because of banks’ market power within the upstream warehouse lending market.
Policy Implications. If shadow banks sell loans rapidly, warehouse costs become small in accordance with overall funding costs, and banks cannot undo this transformation simply by charging more. The model counterfactual implies that enhancements within the secondary markets, particularly within the speed of presidency-backed enterprise loan purchase programs following mortgage origination, would spill in to the downstream mortgage market.
Furthermore, because of the large role of shadow banks in mortgage origination, disruptions within their funding and it is potential spillovers to lending happen to be concerning regulators these concerns have elevated in prominence throughout the ongoing COVID-19 pandemic. Another model counterfactual implies that within an economy having a reduced quantity of banks offering warehouse funding to shadow banks, shadow banks constitute a few of the shortfalls by pivoting to alternative sources, while banks don’t completely counterbalance the shock to consumers. Home loan rates increase and lending declines, suggesting a sizable negative consequence borne by mortgage borrowers as banks withdraw in the warehouse lending market, even when they continue supplying mortgages. Case study supports the concept that disruptions in shadow banks’ funding might have important effects and really should get appropriate attention by regulators.
Overall, the findings reveal the advantages and limits from the development of nonbank financial intermediaries. Banks’ market power within the upstream funding market enables them to have their rents whatsoever competitive downstream credit market, restricting the advantage of the development of nonbank financial intermediaries passed onto consumers. The paper thus uncovers a brand new funnel by which regulatory interventions and technological developments improve consumers’ use of credit by reduction of such funding reliance between financial intermediaries.
Erica Jiang is definitely an Assistant Professor at USC Marshall. Additional information about her research are available on her behalf website.
Buchak, G., Matvos, G., Piskorski, T., & Seru, A. (2018). Fintech, regulatory arbitrage, and also the rise of shadow banks. Journal of monetary Financial aspects, 130(3), 453-483.
Jiang, E., Matvos, G., Piskorski, T., & Seru, A. (2020). Banking without deposits: Evidence from shadow bank call reports (No. w26903). National Bureau of monetary Research.