'Shadow banks,' indebted firms to be launch pad for next crisis, warns Nobel-winner economist

Unregulated shadow banking sector, medium-size and large companies hold much of debt, risk in world economy, says Douglas Diamond, winner of 2022 Nobel Prize in Economics.

'Shadow banks,' indebted firms to be launch pad for next crisis, warns Nobel-winner economist

The world's next major economic crisis will likely erupt out of shadow banks and indebted companies, according to one of this year's Nobel Prize-winning economists. 

In an exclusive interview with Anadolu Agency, University of Chicago professor Douglas Diamond said that while conventional lenders were in a stronger financial position than in the past, their increased risk-averseness freed up certain activities to unregulated "shadow banks."

Diamond, who has devoted most of his career in working on the role of banks during financial crises, shared the 2022 Nobel Prize in Economics with former Federal Reserve Chairman Ben Bernanke and Philip Dybvig, professor of banking and finance at the University of Washington.

The Nobel foundation said all three had "significantly improved our understanding of the role of banks in the economy, particularly during financial crises."

According to Diamond, around 80% of the work he has done in his entire career since 1979 was understanding why banks are structured the way they are and "what good things they can do for the world."

"I had studied -- both in grad school and undergraduate -- the Great Depression of the world in the 1929-1933 period, and I was trying to understand bank failure in that period," he said.

On the current state of banks amid the challenges posed by Russia-Ukraine war, Diamond pointed to a major difference with past instances of economic vulnerability.

"We passed all these laws and regulations in the world after 2008, such as the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), and changes in the eurozone regulation."

According to him, the banks, at least in the US, are in very much stronger financial position now. "So they're more available to take a shot than they were in 2008. So that's good."  

'Many risks in world economy in shadow banks, companies'

Yet, Diamond said there were two challenges in the current circumstance of the banks. "The banks are not going all in on as many of the activities that they would normally go into -- market making for treasury bonds, market making for syndicated loans."

This made the banks less aggressive in those markets, he said, adding that some of the activity the banks would have normally engaged in were now migrating to shadow banks, non-bank financial intermediaries that serve similar roles as commercial lenders but are not subject to normal banking regulations.

"Right now, a lot of the risks in the world economy are in these institutions, which do essentially the same thing as banking, but they're not highly regulated."

Insurance, factoring, and leasing companies, as well as hedge, money market, and structured investment funds are examples of such intermediaries, as are consumer finance institutions and securities companies.  

'We made the regulated sector so strong, that the excessive lending went elsewhere'

Emphasizing that most of the risk in the world economy are in these institutions, Diamond said he sees the transfer of financial risks out of the regulated sector as the world's number-one economic risk.

"We made the regulated sector so strong, that the excessive lending went elsewhere," he said, adding that in the 2008 crisis, corporate finance was not a major problem, shown by the absence of persistent company default.

He explained that the losses that caused the 2008 crisis were internal to the banking sector, due to mortgage finance and the housing market collapse.

Now however, the corporate sector, particularly the medium-size and bigger companies, hold much of the debt, rather than the banks. "There's lots and lots of short term corporate debt that's out there."

He warned that as a result, it's likely that when the next crisis hits, corporations will be the hardest-hit, not the banks.

"Now that'll eventually blow back to the banks. The last one started in the banks, it stayed in the banks. This one's going to start in the shadow banks and the companies. And both of those things, if it causes a real crisis, will blow back to the banks."