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The Shadow Knows...

The Shadow Knows...

May 15, 2023

Created in the early 1930s, The Shadow was an expert detective, a skilled marksman, and a master of stealth and disguise. He wore a wide-brimmed black hat and a black, crimson-lined cloak with an upturned collar. He was created in the superhero genre, with his main superpower being that of invisibility. This gave him the opportunity to be present in the shadows where criminals were lurking. They only knew that he was in their midst from the sound of his voice.


Source: LinkedIn

The Shadow was best known by his alter ego, Lamont Cranston, a wealthy young about-town man. He has had many iterations, starting with a radio show in the 1930s. There have also been comic strips, magazines, and even a 1994 movie in which Alec Baldwin played the title character. Each radio show was introduced with the line “Who knows what evil lurks in the hearts of men? The Shadow knows!”.

There is another shadow lurking in the financial world that very few people are aware of. It is known as the Shadow Banking System. This term is widely used to describe non-bank institutions that act as lenders, providing loans to companies that banks no longer make.

There are many types of financial institutions within the shadow banking system. These include hedge funds, private equity firms, insurance companies, and pension funds, just to name a few. They are defined as non-bank financial institutions or NBFIs. The chart below gives some idea of what this looks like in our financial ecosystem.

Even though you may not have heard this term previously, you were made aware of their presence during the ‘07-‘08 subprime mortgage downturn and Great Financial Crisis. This led to the government takeover of Fannie Mae and Freddie Mac, as well as the eventual failure of AIG and Lehman Brothers, both of which were NBFIs. We found out very quickly the impact that the failure of one of these institutions could have on the financial markets and the economy.

Over the last several months, all eyes have been on the banking sector, as the Federal Reserve Bank continues to raise interest rates. This has caused the value of the government bonds and mortgages held by many of these institutions to go down. This in part led to the failure of a couple of very large, but somewhat unique, banks in the United States.

What is not known currently is the impact these rate increases are having on the shadow banks. These institutions have stepped in and helped fill the lending gap that was created when Dodd-Frank legislation limited the ability of banks to make loans to lower-quality, higher-risk small and midsize companies that needed capital.

We recently saw the Fed, the Treasury, and the FDIC step in quickly to stem risk in the banking system when what was defined as systemically important banks failed. We are uncertain of what would happen if a similar issue occurred with one of these NBFIs. It is important to be aware of this as the asset base controlled by these institutions has nearly tripled in the last 20 years, as you can see in the chart below.

Rising interest rates are putting pressure on banks. So far, we have not heard of significant stress in the shadow banking system. However, we also know that these organizations are not subject to the same regulations and reserve requirements that commercial banks must observe. This is why it is important to pay close attention to what is happening on the ground today.

Each episode of the radio program ended with the reminder “The weed of crime bears bitter fruit! Crime does not pay…. The Shadow knows!” The shadow banks are yet another important aspect of our financial system, and most people are not aware that they are out there lurking about. Part of our job is to keep our eyes open in order to responsibly manage the hard-earned assets that you, our friends and clients, have entrusted to us. This is part of our mission, and it drives us daily as we continue “Moving Life Forward”.

© 2023 Jesse Hurst

The views stated are not necessarily the opinion of Cetera and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.