With no exception, the Shadow Banking System has stirred up a fair amount of controversy over the last few years.  Shadow Banking deals with non-bank finance companies that make loans on a regular basis but are not subject to government regulation; these may include medical leasing companies, military lenders, equipment lessors, and other specialty financiers.  Such finance companies have provided a significant portion of global lending since the turn of the millennium.    In fact, according to a June 2008 speech given by Treasury Secretary Tim Geithner (President & CEO of the New York Fed at the time), non-bank lending now exceeds traditional bank lending in the United States.

Most conversations about the Shadow Banking System focus on the risks of these non-bank lenders.  But let’s face it, traditional banks have proven to be anything but risk-free these days.  I would like instead to concentrate on opportunities for these specialty finance companies.  These lenders have become critical in providing much-needed funds to businesses and consumers, and the Shadow Banking industry isn’t going away anytime soon.

The breakdown of the traditional banking system has impacted us all.  But as bank failures pile up and regulations become more stringent, non-bank finance companies are being hit as hard as anyone.  A number of these specialty lenders have had their lines of credit drastically reduced or cut completely by the big banks they rely on for financing.  As non-bank financing fades, small businesses and consumers ultimately suffer.

Non-bank finance companies must find new ways to continue their lending operations.  Two viable options have emerged in 2009 that allow specialty lenders not only to combat the banking crisis, but to use it to their advantage:

1. Acquire a small bank or thrift. – The biggest advantage to a non-bank finance company of acquiring a bank is the ability to continue its lending operations.  As soon as the bank or thrift charter is secured (and all regulatory requirements are met), the company can once again start originating loans.  But this route provides several other benefits as well.  For example, banks operate at a much lower cost of funds (2.5-4.0%) than specialty lenders (5.5-7.5%).  This means that in the acquired bank, new loan originations can either undercut competition with lower rate offers or can have a substantially higher net interest margin than previous receivables.  Either scenario will ultimately lead to more lending profits.  Like in many other industries right now, if you have capital, you can find some great deals on banks.  Fortunately, capital is not the issue for non-bank finance companies.  While traditional banks must be capitalized at 6-10% of their asset base, most of the non-bank finance companies I have come across are leveraged at 25-40% of their receivables; the excess capital can be infused into the bank for future operations.  In addition, these companies are maintaining profitability because they are able to charge high interest rates on their specialty loans.  Troubled banks are in need of capital to withstand losses on bad loans, as well as earning assets to fill the void on their balance sheets that will be left by charge-offs.  Specialty lenders can satisfy both of these needs.  So, to summarize the acquisition process:  the specialty finance company purchases the charter, assets, and deposits of a bank or thrift for a price; the company’s excess capital offsets bad loans and positions the bank for future growth; the company gets to continue lending and originate new loans at a much lower cost of funds, which increases net interest margins.
2. Partner with a community bank. – Identifying and negotiating a bank partnership can provide many of the advantages of purchasing a bank without the hassle of actually “being in banking.”  The specialty finance company injects capital into the bank; the bank agrees to hold some or all of the company’s receivables on its books; the company continues lending uninterrupted (and at a lower cost of funds), and the bank gets to show earning assets on its balance sheet.  The potential drawback to a partnership as opposed to an acquisition is that receivables on the bank’s books may be limited to a certain percentage of the bank’s asset base.  The key to a partnership is to find a bank with the right size and makeup to correspond with the company’s portfolio.

Both options above offer feasible alternatives to assistance from big banks, which are in no position to lend any time soon.  However, whether it be acquiring a bank or finding a bank partner, I highly recommend working with a consulting firm with expertise in community banks and regulatory interaction.

The time has come to generate new ideas for the future of the financial industry.  I have seen first-hand the struggles of these specialty lenders as they forfeit one line of credit after another.  I can only hope more and more of them will begin to act before Shadow Banking goes the way of traditional banking.