Shadow Banking Can Topple The Financial Industry

New article by our team:  Shadow Banking Can Topple The Financial Industry

The Fed has recently published an update on consolidated assets and liabilities of domestically chartered banks. In 2024, the sector’s total credit portfolio was up 2% YoY. At first glance, this figure looks okay given the current lending conditions and the interest rate environment. However, a closer look at the numbers tells a different story. The majority of this growth was driven by loans to shadow bankers, which grew 15% YoY. By comparison, residential real estate loans increased by 2% YoY, and commercial & industrial lending was up 1%.

Shadow lending is dominated by large U.S. banks, which granted 86% of these loans. As shown below, loans to shadow bankers have increased massively over the past several years.

As of the end of last year, domestically chartered banks and foreign-related institutions granted $902B and $255B to shadow lenders, respectively. As such, the total sector’s shadow banking-related portfolio is almost half of total residential real estate loans. By comparison, in 2020, shadow banking credit portfolio accounted for 25% of residential real estate loans.

Importantly, these numbers show only the balance sheet exposure of the banks to shadow lenders. Last year, the NY Fed provided data that looks beyond the balance sheets and analyzes contingent liabilities. As the chart below shows, these liabilities are greater than $1.5T, i.e., even higher than balance sheet exposures.

Notably, even the regulators have started to raise concerns about shadow lenders. Klass Knot, the head of the Financial Stability Board (FSB), said that shadow lending is a key concern area. There was also an interview with Elizabeth McCaul, a member of the European Central Bank’s supervisory board, who said that the “remarkable” growth of non-banks was the biggest threat to the stability of the Eurozone’s financial system. Finally, Michael Hsu, former CEO of the Office of the Comptroller of the Currency, told the Financial Times when asked about shadow banking lenders that “he thought the lightly regulated lenders were pushing banks into lower-quality and higher-risk loans.”.

Yet, none of the global regulators have introduced regulatory measures in the shadow banking segment. In fact, lending to shadow banking has accelerated in the second half of 2024.

If we look at regulation and underwriting standards in the mortgage segment before the GFC and compare them with those of shadow banking credit in 2025, we’ll see that they have quite a few similarities. Back then, the mortgage segment was also regulated very lightly, and banks were granting extremely risky loans with very high loan-to-value ratios to low-quality borrowers with very poor debt-to-income ratios.

Bottom line

Believe it or not, there are more major issues on the larger bank balance sheets as compared to smaller banks, which we have covered in past articles. Moreover, consider that there was one major issue which caused the GFC back in 2008, whereas today, we currently have many more large issues on bank balance sheets.

These risk factors include major issues in commercial real estate, rising risks in consumer debt (approaching 2007 levels), underwater long-term securities, over-the-counter derivatives, and high-risk shadow banking (the lending for which has exploded). So, in our opinion, the current banking environment presents even greater risks than what we have seen during the 2008 GFC.

Almost all the banks that we have recommended to our clients are community banks, which do not have any of the issues we have been outlining over the last several years. Of course, we're not saying that all community banks are good. There are a lot of small community banks that are much weaker than larger banks. That’s why it's absolutely imperative to engage in a thorough due diligence to find a safer bank for your hard-earned money. And what we have found is that there are still some very solid and safe community banks with conservative business models.

So, I want to take this opportunity to remind you that we have reviewed many larger banks in our public articles. But I must warn you: The substance of that analysis is not looking too good for the future of the larger banks in the United States, and you can read about them in the prior articles we have written.

Moreover, if you believe that the banking issues have been addressed, I think that New York Community Bank is reminding us that we have likely only seen the tip of the iceberg. We were also able to identify the exact reasons in a public article which caused SVB to fail. And I can assure you that they have not been resolved. It's now only a matter of time before the rest of the market begins to take notice. By then, it will likely be too late for many bank deposit holders.

At the end of the day, we're speaking of protecting your hard-earned money. Therefore, it behooves you to engage in due diligence regarding the banks which currently house your money.

You have a responsibility to yourself and your family to make sure your money resides in only the safest of institutions. And if you're relying on the FDIC, I suggest you read our prior articles, which outline why such reliance will not be as prudent as you may believe in the coming years, with one of the main reasons being the banking industry’s desired move towards bail-ins. (And, if you do not know what a bail-in is, I suggest you read our prior articles.)

It's time for you to do a deep dive on the banks that house your hard-earned money in order to determine whether your bank is truly solid or not. Feel free to review and utilize our due diligence methodology here.