Tighter rules for commercial lenders drive growth in shadow banking, writes Tracy Alloway

Cocktails, cabanas and credit quality were some of the talking points at a commercial real estate conference held this week in Miami, as attendees swapped their overcoats for beachwear and sat down to discuss the rebounding market.

The annual summit has for years been a calendar highlight for the Wall Street bankers who originate commercial real estate loans and then bundle them into bonds known as commercial mortgage-backed securities (CMBS).

This year’s event was held at the Fontainebleau, a more upscale – and, crucially, larger – venue that offered attendees an on-site nightclub and a spa with “Swarovski crystal pedicures” on its menu of services.

The sprawling new location is symbolic of the broader recovery in some parts of the securitisation market. Sales of CMBS totalled $102bn last year, the highest since the financial crisis, and issuance is expected to increase further in 2014. It is also indicative of another development: in addition to accommodating the hundreds of bankers who have historically frequented the conference, this year’s Miami gathering played host to an expanded selection of non-bank lenders.

Most notable were the large numbers of representatives from non-traded real estate investment trusts (Reits) – tax-friendly investment vehicles that invest in property and also originate new loans.

While that is a deeply uninteresting description of their activities, these non-traded Reits are often included under the far more intriguing label of “shadow banks”.

There has been an increasing amount of talk recently about the growth of “shadow banking” – most of it supremely unflattering. Shadow banks, we are often told, are the unregulated institutions that lurk in the dark corners of the financial system – away from the supervised activities of run-of-the-mill commercial banks.

The frequent implication is that these indistinct entities are growing as new financial regulation begins to have an impact on the activities of traditional banks, and that this growth poses a threat to the safety of the overall financial system.

Yet, just like banks, shadow lenders serve a purpose – they create the credit and securities that are demanded by investors and, hopefully, supported by the needs of the real economy.

The growth of shadow lenders is therefore demonstrative of a truism of finance: squeeze one segment of the system and the activity you are attempting to control is likely to manifest itself elsewhere.

If banks retreat from the business of manufacturing in-demand assets such as CMBS or originating loans, you invite growth of non-bank lenders which do the same thing in a cheaper and more efficient way. Reits enjoy lighter regulation, benefit from tax efficiencies and possess increasingly deep pockets that allow them to make aggressive loans to property developers.

Their role in the market is growing – as is that of hedge funds and “business development companies” that provide capital to middle-market companies, and a whole host of other speciality financiers.

At the Miami conference, upstart non-bank lenders carried pitch books to sell their businesses to yield-hungry investors, raising expectations that more than 10 new firms will this year begin contributing loans to CMBS deals, according to Kroll Bond Ratings.

While it’s fair to worry about the rise of shadow lenders themselves, it seems there is perhaps also an under-appreciated danger: the possibility that non-bank lenders will encourage riskier behaviour at larger banks that now find themselves compelled to try to compete with the shadows.

Competition is increasing and the poolside bonhomie that pervaded the Miami conference may not last should bankers see their business (or bonuses) eroded by their shadow lender counterparts.

Already there is talk of slippage in underwriting standards across the board and the return of certain worrying pre-crisis lending practices as competition heats up.

Next week, it’s off to another, even larger, conference – an annual securitisation industry shindig in Las Vegas.

Here, too, the event has been moved to more luxurious accommodation than has been booked in prior years – the swanky Cosmopolitan Hotel on the glittering Las Vegas Strip.

Expect the mood there to be as buoyant as in Miami, and the attendees just as varied. What will be interesting to see is how regular conference-going bankers react to the proliferation of party-crashers from the world of shadow lending.

After all, there are only so many free cocktails to go around.