Banks have had to prune back their lending but other forms of finance have found space to blossom
Spring is in the air as a dark winter for the banking sector has allowed new forms of financing to take root. A range of financing options has sprung up to service businesses left out in the cold by banks. This is more than just a temporary reprieve from the current dearth of funds from banks. It could instead be part of a bigger shift whereby banks are no longer the main source of lending. This development appears to be a good thing for the economy but the full ramifications will only become clear with time.
Diversification in financing
Banks had long been the big trees in the financial jungle. Their network of branches spread far and wide and claimed the bulk of the chances to provide funds to the economy. Few opportunities filtered through to other forms of funding, which remained small in comparison. The global financial crisis has opened up the possibility of change with banks having been poisoned by toxic debt. Access to credit all but withered away after the crisis cut down a few banks and clipped many others.
The problems in the banking sector are mostly self-inflicted. There is a glut of cash available for loans but banks are too concerned with their own survival to be in a position to facilitate lending. A range of companies have sprouted up between the cracks to provide the funding needed to nourish the economy. These new firms have been labelled as the shadow banking sector and tap into money from a range of sources such as pension funds and businesses outside of the finance sector, as well as from people like you and me through peer-to-peer lending sites.
The diversity of routes for lending solves one of the problems with the banking sector. Deposits were not enough to provide banks with all the money that was needed in the lead up to the global financial crisis. Instead, banks sucked up funds from the money markets where it was possible to borrow for a few months. This is not an issue when funds flow freely but the money dried up when the crisis struck. On the other hand, the money being put to use by the new firms comes via an assortment of different arrangements and many, such as pension funds, are willing to offer up cash for longer periods.
When more is better
The growth of the many new sources of financing seems to be positive. As in nature, higher levels of biodiversity help to build a more robust funding ecosystem. Such funding operations are still just saplings. Yet, there is the potential for a future forest of financing options. Some parts of the new setup may even grow to rival the lending capabilities of banks. This has only come about through the irony of banks jeopardising their long-term prospects and opening up opportunities for others due to their need to lend less to ensure short-term survival.
There is a further benefit in that any shrinking of banking operations should be beneficial over the long term. This is because the current rules for banking mean that banks have too much scope to get themselves into trouble. Not all is rosy however, with some of the new firms facing criticism from the public despite seemingly meeting a genuine need (such as Wonga). The new range of financing options may also include potential problems lurking under the surface. But this could be somewhat accommodated by central banks and other regulators broadening their oversight.
The flowering of new funding options may be one of the few bright spots in the aftermath of the global financial crisis and could help to ensure that the economy won’t have to go through a drought in finance again.