Where are the seeds of the next financial crisis?

Speaking at the Conference of State Bank Supervisors, Comptroller of the Currency Thomas Curry discussed threats to the national banking system and warned listeners about the dangers of the “shadow banking system.”

As regulatory scrutiny on banks intensifies, assets are shifting from regulated depository institutions to lesser-regulated institutions, Curry explained, resulting in an unbalanced system – and the potential for serious problems.

“In the wake of the financial crisis, the regulation of insured depository institutions has become much more rigorous, as it should,” Curry told attendees. “But as we add safeguards, beef up capital requirements, and raise standards, some activities are almost certain to migrate out of insured financial institutions into what is often called the shadow banking system. We are seeing that clearly in the area of mortgage servicing rights, which is shifting from bank servicers to nonbank companies as a result of the new capital rules.”

The Consumer Financial Protection Bureau will fill certain gaps, the Comptroller said, by writing new rules and supervising some nonbank entities. But state regulators need to step up and do their part.

“The shift of financial assets into the shadow banking system could carry with it the seeds for the next financial crisis if we do not act quickly and effectively,” Curry cautioned. “We can’t tolerate a situation where banking activities migrate to nonbank financial institutions in order to escape prudential supervision.”

State regulators should conduct balanced supervision of both bank and nonbank institutions, Curry advised. “Much of the burden for regulating the shadow system will fall upon the states, and I would encourage you to make this a high priority.”

Just a few days later, Superintendent of New York’s Department of Financial Services (DFS) Benjamin Lawsky echoed Curry’s concerns in remarks to the Mortgage Bankers Association. He also cited nonbank mortgage loan servicers as an example of the potential for a “race to the bottom” where homeowners and investors “are at risk of becoming fee factories.”

As banks offload mortgage servicing rights to lesser-regulated nonbank mortgage servicers, some servicers – being paid a flat fee – try to provide their services as cheaply as possible to maximize profits. “Regulators have a responsibility to ask whether the purported ‘efficiencies’ at nonbank mortgage servicers are too good to be true,” Lawsky said.

Some servicers also offer ancillary services like property inspections or foreclosure sales, he added, deciding how much to charge the borrower or investor with limited oversight. “The potential for conflicts of interest and self-dealing here are perfectly clear,” Lawsky said. “Servicers have every incentive to use these affiliated companies exclusively for their ancillary services, and they often do. The affiliated companies have every incentive to provide low-quality services for high fees, and they appear in some cases to be doing so.”

Answering Curry’s call, Lawsky said the DFS plans to increase its focus on nonbank servicers, particularly in the mortgage industry. “We’ve publicly highlighted our concerns about ancillary services with one particular nonbank servicer, but they are not the only industry player doing this,” he noted.

To read Comptroller Curry’s prepared remarks, click here.

To read excerpts from Superintendent Lawsky’s speech, click here.

Why it matters: The “shadow banking” term is used to address unregulated competitors of banks (mortgage brokers and servicers, non-bank auto and payday lenders, private equity firms, PayPal, Google and Bitcoin) as well as functions in the financial system which are being targeted for more regulation (repurchase agreements, asset securitization, the secondary mortgage market). After the financial crisis, banks have been the focus of state and federal regulators for increased regulation and capital and liquidity requirements, often to the competitive disadvantage and potential demise of the traditional bank business model. However, going forward, potential systemic risk is likely to be regulated wherever regulators identify it – including in the shadows of the financial system.