The financial sector is buzzing with discussions on shadow banking, with top regulators warning about its potential risks to global stability. Shadow banking, or non-bank lending, is not a new concept, but its rapid growth and increased ties to traditional banks have regulators concerned about its impact on the financial ecosystem. Recent statements from financial watchdogs, including Klass Knot of the Financial Stability Board (FSB) and Elizabeth McCaul of the European Central Bank, stress the vulnerabilities shadow banking presents, particularly in light of rising non-performing loans and deteriorating asset quality among smaller financial institutions like First & Peoples Bank.
Shadow Banking: A Growing Concern for Financial Stability
The FSB and other regulatory bodies are focused on the “remarkable” growth of shadow banking—especially as large U.S. banks have funneled over $1.1 trillion in loans to shadow lenders as of September. According to Fed data, nearly 65% of these loans originate from the largest 25 banks in the country. This concentration reflects the scale of risk undertaken by major financial institutions, but it also shows that shadow banking is not just a “big bank” issue. With smaller banks like First & Peoples lending around $400 billion to shadow intermediaries, these risks have trickled down, impacting the wider financial landscape.
The First & Peoples Bank Case: A Cautionary Tale
The story of First & Peoples Bank, a community bank based in Kentucky, serves as a stark example of the risks shadow banking can pose—especially when proper oversight is lacking. In 2020, First & Peoples entered a partnership with the fintech company US Credit, outsourcing much of its loan servicing operations. US Credit was responsible for originating, servicing, and collecting on loans. However, this partnership quickly proved disastrous as US Credit made high-risk lending decisions without bearing any credit risk. The result? Significant loan defaults that have left First & Peoples Bank in a perilous financial position.
By September, First & Peoples faced a 23.4% non-performing loan ratio, amounting to over $25 million, which dwarfs its $16 million equity base. In effect, the bank is currently “underwater,” with losses threatening its solvency. While the terms of its partnership with US Credit remain undisclosed, it’s clear that entering into an arrangement that outsourced credit risk assessment was a costly misstep.
Chasing Profitability: A Look at First & Peoples’ Financial Metrics
First & Peoples’ partnership with US Credit can likely be traced back to a drive to boost its return on equity (ROE). Community banks typically rely on stable, low-risk lending models. But over the years, First & Peoples’ ROE lagged behind its peers, reflecting lower profitability. ROE, calculated as net profit divided by equity, is a crucial measure of a bank’s capital efficiency. For First & Peoples, however, it’s been a long-standing challenge.
From 2016 to 2020, First & Peoples’ ROE consistently trailed that of comparable banks. While the partnership with US Credit initially bolstered ROE in 2021, the improvement was fleeting. By 2022, escalating defaults reversed these gains, and ROE plummeted, highlighting the dangers of relying on high-risk lending to boost short-term profitability.
Operating Efficiency and the Cost of Risk
Another area where First & Peoples faced challenges is its efficiency ratio—an important metric that evaluates how effectively a bank controls non-interest expenses relative to its income. Initially, First & Peoples’ efficiency lagged behind its peers. However, in 2021, with US Credit taking over loan servicing, First & Peoples reduced credit risk management costs, temporarily improving its efficiency ratio. But as with ROE, this improvement didn’t last. Defaults surged, and by early 2022, the bank’s cost of risk—a measure of its provisioning for loan losses—spiked, leaving the bank exposed to mounting losses.
In hindsight, First & Peoples might have exited its partnership with US Credit as soon as asset quality concerns became evident. Yet the bank continued the partnership, which eventually led to substantial losses, revealing the risks of high-cost, high-risk lending strategies for smaller financial institutions.
Depositor Confidence Amid Mounting Losses
One surprising element in this saga is the stability of First & Peoples’ deposits. Despite ongoing financial struggles, deposit levels have held steady, outperforming even some larger banks during the same period. This trend suggests that retail depositors, potentially relying on FDIC insurance, have not fled the bank despite its deteriorating financial condition. Interestingly, as of September, First & Peoples still had 65 accounts exceeding $250,000—the FDIC insurance limit—totaling $33 million in uninsured deposits. This could imply a lack of awareness among depositors regarding the bank’s troubles.
Lessons for Retail Depositors and Community Banks
The case of First & Peoples Bank serves as a wake-up call for community banks and retail depositors alike. For community banks, the allure of partnerships with shadow banking entities, particularly fintechs, can be tempting but fraught with risks. Financial institutions must carefully assess the long-term impact of such partnerships, especially where credit risk is outsourced.
For depositors, it underscores the importance of conducting due diligence. Deposits may be insured up to $250,000, but as seen with First & Peoples, a seemingly stable community bank can face steep declines due to hidden financial risks. Reviewing a bank’s financial health—even at a basic level—can help depositors make more informed decisions, especially if they are investing significant amounts that exceed FDIC protection limits.
Final Thoughts
As shadow banking continues to grow, regulators will likely increase scrutiny on both large and small institutions engaged in high-risk lending practices. For our part, we encourage retail investors to stay informed about the financial health of their institutions and advocate for greater transparency in the banking sector. Shadow banking’s growth and the increased exposure of community banks to high-risk lending warrant ongoing vigilance, and only time will tell how these dynamics will impact the broader financial system.
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