Let's not kill the shadow banking system

Although the U.S. economy seems to be recovering, albeit slowly, the Obama administration, members of Congress and many economists worry that small businesses aren't recovering as quickly as large ones.
APR 18, 2010
By  MFXFeeder
Although the U.S. economy seems to be recovering, albeit slowly, the Obama administration, members of Congress and many economists worry that small businesses aren't recovering as quickly as large ones. This is troubling because small businesses create a disproportionate share of new jobs. Unemployment isn't likely to drop significantly until small companies begin to grow again. Many politicians and small-business owners complain that small-business growth is being hampered by an inability to get bank loans. The banks claim that they are lending, but carefully. One unspoken part of the problem is the condition of the shadow banking sector, more formally known as the securitization markets. Compared with the formal banking system, which appears to be recovering (even though many small, regional banks have failed and more such failures are likely), the shadow banking system is barely alive. In boom times, the major banks could securitize and sell off at least some of their small-business loans, just as they packaged and sold off mortgages, car loans and credit card loans.

FEW BUYERS

Now there are few buyers for such securitized IOUs, a fact that also is hampering car sales and the housing industry. Investors are staying away from the securitization markets in part because they were burned when the real estate bubble burst. Investors discovered that the credit ratings applied to mortgage- and other asset-backed securities by the ratings agencies bore little resemblance to the reality of the riskiness of the securities. If lenders can't free up capital by selling off at least some of their loan assets, they will make fewer loans. That hampers the ability of small businesses to expand, because they can't finance capital investments or inventories. It also harms sellers of big-ticket items, such as auto dealers and homebuilders, because potential customers can't get auto loans or mortgages. In short, the weakness in the shadow banking sector is contributing to the weakness of the recovery, and part of the weakness in the sector is attributable to uncertainty about the rules that will apply. The Obama administration and Democrats in both houses of Congress have proposed that lenders be required to keep “skin in the game” by retaining 5% of the credit risk of any loans they securitize. This would address the belief that banks and investment banks made risky loans before the financial crisis to offload risk. Had they been required to keep some of the loans on their books, they might have been more careful in the loans they originated — or so the theory goes. Others argue that better disclosure and stronger regulation of when banks must buy back troubled loans would be a better way to fix the market. They note that companies such as Lehman Brothers Holdings Inc. got into trouble because they kept too many of the bad mortgage-backed securities on their books, not because they sold off too many. They also argue that the requirement that would make banks hold 5% of any such securities, combined with accounting rules that would require them to hold regulatory capital against the full value of any securitization in which they held a meaningful interest, would dissuade most banks from securitizing their loans. Treasury Secretary Timothy Geithner and the leaders of the appropriate committees in Congress must carefully consider the objections of the bankers before the financial-reform bill is passed into law. It isn't too late to reconsider the sections that affect the shadow banking industry to make sure that any such changes fix the system, not kill it.

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