Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks
Non-fintech and fintech shadow banks have seen a remarkable increase in the residential loan market since 2007. Shadow banks’ share in the mortgage market has tripled in the 2007-2015 period. Two questions follow from such a change: 1) What are the reasons for this change? and 2) What are the consequences? Shadow banks are not funded with deposits, and as such, are not bound by stricter regulations as are traditional banks. As a result, shadow banks are open to assume some of the more regulated tasks in the mortgage market, where traditional banks cope with stricter rules. This is a concern for policy makers should this lead to poorer lending policies.
The authors find that shadow banks are most prevalent: 1) in areas with the strictest regulations; 2) where a higher population of visible minorities reside; and 3) in the refinancing market. They also discover that a third of all loans originating from a shadow bank stem from fintech shadow banks, which have a larger market share in counties that have a higher percentage of population with bachelor degrees as well as a lower percentage of minorities. The share of refinancing loans within shadow banks is also bigger for fintech than for non-fintech banks. Do fintech banks deliver better products, or are they simply cheaper? The authors find that interest rates are level between traditional banks and the average shadow bank; however, within shadow banks, the interest rates from fintech loans are higher. As the least creditworthy are given lower interest rates and the most creditworthy are given higher rates, the authors suggest that fintech shadow banks can price discriminate as long as customers are willing to pay for the easy access to fintech loans. Furthermore, the interest rates among fintech borrowers show more variation in prepayment outcomes than variation among non-fintech borrowers. This suggests that fintech banks can better screen borrowers.
Stricter regulations may not necessarily be in the best interest of bank clients. When traditional banks are driven out of the market, the gap is then filled by actors that do not have to comply with the stricter rules. While interest rates on loans originating from traditional banks and shadow banks are on par, fintech banks, on the other hand, do charge higher interest rates. As a result, younger, more educated borrowers are willing to pay for easy access to loans. Whether this is in the interest of these borrowers remains to be seen.