Modern Financial Intermediation
Amit Seru | Episode 59
Amit Seru joined Markus’ Academy for a talk on his recent work on modern financial intermediation (Buchak et al., 2024). Seru is a Professor of Finance at the Stanford Graduate School of Business, a Senior Fellow at the Hoover Institution and Stanford Institute for Economic Policy Research (SIEPR), and a Research Associate at the National Bureau of Economic Research (NBER).
Watch the full presentation below.
Highlights
The traditional view of banking where deposit taking institutions originate most loans in the economy and keep these loans on their balance sheets is obsolete. The modern view of the intermediation is different and needs to incorporate two major aspects: activity that has migrated to shadow banks and changes to business model of traditional banks.
The first aspect is important because non-deposit taking shadow banks now moderate a large part of lending and other activities. Importantly, shadow banks have not penetrated all sectors of the economy in the same way. Thus it is important to understand the segments in which shadow banks are able to compete well with banks and the ones in which they cannot. For instance, in the mortgage market, shadow banks haven’t gained market share uniformly — they have mainly increased their share in the government mandated “conforming market” rather than in the private “jumbo market”.
The second aspect is important because banks are increasingly originating loans to distribute (OTD) them (i.e.,securitizing them). This is a phenomenon across various loan activities. For instance, banks sell a vast majority of conforming mortgage loans they originate (to Government Sponsored Entities, GSEs). Interestingly the extent of retention versus selling by banks depends on their balance sheet capacity. Those with substantial balance sheet capacity tend to retain more than other banks.
Shadow banks have a different business model from banks, where they retain very little and mainly sell to GSEs. Thus one can imagine the intermediation sector doing lending having a spectrum of lenders with different business models — shadow banks with OTD model on one end and banks with strong balance sheets doing significant retention and some OTD on the other end. Weakly capitalized banks doing more of OTD and less of retention would be somewhere in the middle.
Another aspect that is important is how banks and shadow banks fund their activities. Shadow banks finance their activity with much more equity compared to banks.
Seru proposes that the modern view of intermediation — and regulatory framework around it — needs to consider all these aspects. This implies appreciating industrial organization (i.e., competition between banks and shadow banks), business models of intermediaries and the equilibrium interactions between them. The model has a rich demand side that captures consumer heterogeneity driven by demographics as well as a supply side that takes into account different kinds of lenders (i.e.., traditional banks, non-fintech shadow banks and fintech shadow banks) as well as regulations they face (in particular for banks, capital requirements and regulatory burden).
The estimated model allows Seru to conduct counterfactuals related to different regulations and policies. The model illustrates the importance of the two aspects — the shadow bank migration channel and the bank balance sheet retention channel and how these interact with different policies in non-obvious ways when thinking about different dimensions such as aggregate lending, bank stability (based on risk on bank balance sheet) and redistribution. For instance, research found that increasing capital requirements from 6 to 7.5% doesn’t greatly change aggregate lending. Activity migrates to shadow banks and banks move from retention to OTD and together these counteract most of the contraction of lending that occurs on bank’s balance sheet due to raised capital requirement. On the other hand Secondary market interventions such as QE dramatically impacted aggregate lending because both aspects — migration to shadow banks and banks selling rather than retaining — are amplified by such policies. These policies have very different redistributional effects. For example, increasing capital requirements in the mortgage market will most impact wealthy borrowers in high house price areas. This is not the case for policies such as QE. The exact nature of redistribution depends on the market structure and industrial organization of banks and shadow banks
Modern intermediation viewed this way also allows us to look at shadow bank choices and ask how much lending is possible with much higher capitalization. Shadow banks are able to do as much lending as banks (if not more) with substantially higher equity, no deposits (and no branches). This suggests that concerns that higher equity capitalization of banks — implying fewer deposits — might adversely impact lending might be unfounded.
Regulatory burden/pressure is not just about capital requirements. Regulatory pressure on banks explains where banks retreated and shadow banks entered in significant ways.
Modern intermediation also implies a different outlook on the nature of debt relief transmission during periods of distress. The changed nature of intermediation does not only impact how we think about aggregate lending and other outcomes in response to regulations and other policies. Because a large amount of activity is moderated by shadow banks — who have different balance sheet and liquidity management than banks — the debt relief passed by these entities to the real economy is quite different. For instance, forbearance to households was passed at a much lower rate by shadow banks relative to traditional banks under the CARES act passed during the current pandemic. Such ex post effects are to be expected given the changed nature of intermediation.
Several open questions remain:
What activities (such as lending, payments etc) can banks do without deposits (like shadow banks)? This has implications on what activities might be bundled or unbundled as banks face competition from fintechs and other shadow banks.
It also remains unclear what type of loans banks decide to sell versus retain on their balance sheet.
Another aspect that deserves attention is the intriguing pattern that uninsured leverage for both banks and shadow banks increase with size.
Finally, given the complexity in the system, should we focus on fine tuning regulation by moving many complicated pieces together or might requiring banks to hold higher equity be a simpler solution.
In conclusion, views and regulations focused only on bank balance sheets are very incomplete. Assessing financial stability in this modern era involves understanding the business model of shadow banks and traditional banks, the industrial organization of the market and the equilibrium interaction of intermediaries.